Leveraging Equity Analysts for ETF Ideas

Although exchange-traded funds are often thought of as passive vehicles, active investors in ETFs can still benefit from equity research. Morningstar has over 100 equity and credit analysts who conduct fundamental analysis on companies, focusing on sustainable competitive advantages and a discounted cash flow-derived fair value. Since these data can be aggregated to the fund level, we can form an estimate of the worth of the ETF, which is only worth what the constituent parts add up to.

We can use their research to form thematic ideas about which sectors appear attractive and which to avoid. ETFs are a great way to implement thematic ideas because the diversification inherent in a fund avoids the idiosyncratic risk of single stocks. While picking individual stocks offers the potential for spectacular returns, we can gain some efficiency by using sector or industry ETFs. After all, a rising tide tends to lift all boats. Based on their analysis, the financial and heath-care sectors are currently the cheapest sectors on a price/fair value basis. The two most expensive sectors on a price/fair value basis are energy and materials.

Financials: Stick With Large-Cap Banks
Many of the large money-center banks have repaid TARP funds and are now much better capitalized. Remember when bank stocks rallied after the successful conclusion of the "stress tests" in 2009? It worked so well the first time; the government is going to run it again. The Fed wants to evaluate how fit the banks are and if they are capable of paying out larger dividends. Nineteen banks will submit plans to the Fed seeking eligibility to raise dividends or buy back stock, or in the case of a handful of big banks that have not repaid TARP (such as  Regions Financial (RF)), how they plan to repay TARP. Those banks that can not repay TARP may become acquisition targets, such as  Marshall & Ilsley . Despite its conservative Wisconsin roots, MI got overzealous with expansion into Nevada and Florida, and the only way it can pay back TARP is through a lifeline from  Bank of Montreal (BMO).

In one sign of good news,  Bank of America (BAC) reached a settlement with the government-sponsored enterprises regarding mortgage buybacks. Not only does this remove an unknown, it sets a standard for any future private settlements that is perhaps lower than what markets at one time feared. On the larger-cap financials, James Sinegal, Morningstar's associate director covering financials states that "the high-quality, narrow- and wide-moat names we typically favor ... have worked through many of their problems and are set to go on the offensive again, perhaps by acquiring troubled peers." On the other hand, there is still some concern about small-cap banks, many of which have not repaid TARP money. You can read more from James Sinegal here.

The investment thesis for financials is that large-cap banks have an attractive valuation and are resolving their problems. As for how to implement this financials idea with an ETF, we like  SPDR KBW Bank (KBE), which owns 24 of the largest banks in the United States. Its market-cap weighting results in a large exposure to  J.P. Morgan Chase (JPM),  Citigroup (C), Bank of America and  Wells Fargo (WFC), all of which we believe are significantly undervalued. Because we find the value of smaller banks less compelling, we would avoid  SPDR KBW Regional Banking (KRE), which equal weights 50 smaller regional banks. The average market cap for KRE is about $1 billion compared with $22 billion for KBE.

Health Care: One of the Few Sectors Adding Jobs
Few sectors of our economy have experienced consistent growth, but one of them is health care. While total nonfarm payrolls are essentially flat over the past 10 years, employment in the health-care industry is up 30%. Alex Morozov, Morningstar's associate director covering health care, said patient admission rates are starting to improve and the removal of co-pays for preventative care should boost demand. He goes on to say that "the marketplace appears to be extrapolating near-term suppressed revenue growth onto long-term projections for the sector." M&A activity should remain an important driver of valuations in 2011. A number of health-care ETFs trade at attractive price/fair values, including  Health Care Select Sector SPDR (XLV), which trades at a price to fair value of 0.84,  iShares Dow Jones US Medical Devices (IHI), which trades at 0.88, and  iShares S&P Global Healthcare (IXJ), which trades at 0.89 and benefits from some international diversification.  Pharmaceutical HOLDRs  is the cheapest health-care related ETF, thanks in part to its concentration in "big pharma." It owns several 5-star stocks, including  Pfizer (PFE), and  Abbott Laboratories (ABT). However, the fund is not very well diversified, as it has 24% of its assets in  Johnson & Johnson (JNJ).

Energy and Materials: Fairly Priced and Facing Rising Commodities Prices
Two of the more expensive sectors on a price/fair value basis are materials and energy. There is little doubt that strong economic growth in emerging markets is fueling demand for commodities. And while the higher prices would benefit materials and energy companies that produce the underlying commodities, it would likely hurt refiners' margins, as U.S. consumers are less able to afford those products.

According to the U.S. Energy Information Administration, between 2000 and 2009, petroleum consumption in the United States was down by about 1 million barrels a day, but total world consumption was up by about 10 million barrels a day. Petroleum consumption in China has nearly doubled in just 10 years. To meet that growing demand, prices have to rise to justify the higher marginal cost of production of digging for harder-to-reach resources. A firm that derives a large part of its revenues and has a large part of its assets tied to the underlying commodity should benefit, while a firm that has to buy the commodity on the open market only to resell it to the cash-strapped American consumers will see margins squeezed. Thus, we like firms such as  ExxonMobil (XOM), which trades at a price/fair value of around 0.86, while we would avoid a firm such as  Valero (VLO) or  Sunoco , which are both overvalued at 1.11 and 1.32, respectively. Allen Good, Morningstar equity analyst covering refiners sees limited upside left in refiners, as he notes in this report.

To implement our thesis on rising oil prices, we examined two different energy-themed ETFs.  IShares Dow Jones US Oil & Gas Exploration & Production Index (IEO) has a price/fair value of 1.01 and has none of its assets in wide-moat stocks, while  iShares Dow Jones US Energy (IYE) has a price/fair value of 0.96 and 24% of its assets in wide-moat stocks. While energy-stocks funds are not very compelling, we see oil prices rising. In this research note, Eric Chenworth makes the case for higher prices, and he summarizes his thesis by saying "record global demand, falling inventories, and a shrinking supply cushion bodes well for oil prices entering 2011." We might be tempted to go long the commodity through an ETF. However, there are a number of problems with ETFs that attempt to track oil, such as the contango, which results from factors such as high storage costs. Despite posing capital markets risk, equities can be a better way to invest in oil for the long term, as a firm like XOM owns vast oil reserves with virtually no storage costs. So, despite the fact that the equity ETFs are not particularly cheap on a price/fair value basis, a bullish outlook on oil prices may make sticking with the equity ETFs a good idea.

The strong global demand and tight supply dragging oil prices higher also applies to materials.  iShares Dow Jones US Basic Materials (IYM) is one of the more expensive ETFs on a price/fair value basis, trading at 1.14. However, there are some attractive areas, such as  Market Vectors Steel ETF . Morningstar associate director Elizabeth Collins gives a good summary of the materials sector here.

While ETFs make a great tool for building portfolios and gaining both passive and active exposure, it is still important to conduct a fundamental review of the underlying holdings in your portfolio. Morningstar offers a variety of research tools to get you started.