The explosion of exchange-traded
funds (ETFs) isn't just changing the way investors manage their money, but the
way they evaluate funds.
Up until recently, ETF focused
investment research was hard to come by, but not anymore.
A new wave of companies have targeted the emerging
business of ETF data services and one such company has been quietly producing
much needed research.
Michael Krause, the President of
New York-based AltaVista Independent Research visits with us.
Q: What's
the problem with ETF research from your perspective?
MK: Most of it is really warmed-over mutual fund
research, which focuses primarily on past performance and fees. That’s a problem
because it’s backwards looking, and because it has little if any predictive
value for an ETF.
Therefore the important question has to be, “What is the investment merit of
that particular index?”
Q:
There are so many ways to evaluate an ETF;
there's the underlying stocks within the index, then too there's fees, also what
about the fund company behind the product? Which of these factors are the most
important?
MK: If you were
considering buying stock in General Electric—which after all is a collection of
businesses not entirely unlike an ETF—then you would probably start by examining
the fundamentals. This includes sales and margins, earnings growth, what’s
happening on the balance sheet, etc., and how the stock was valued both against
industry peers and versus the broader market.
Because
ETFs are entirely transparent, unlike mutual funds, all those things can be
known. It is possible to calculate expected earnings per share, earnings growth,
and the P/E ratio, among other data points, from the underlying constituents.
Using this information we can then make much more informed
decisions—forward-looking decisions—about which ETFs make the most sense for our
portfolios.
Q:The technology sector has been dead money
over the past several years and the unfolding stock options scandal hasn't been
a big confidence booster. What do you make of the backdating options probe?
MK: I’m in the minority on this
one—and as a Value guy it’s a bit awkward defending Tech—but I see stock options
as a non-issue.
In terms of stock option
expensing, the market does not pay for changes in accounting rules. In 2002 the
Financial Accounting Standards Board eliminated the amortization of goodwill,
which like stock options is a non-cash expense. The move raised S&P 500 EPS by
about $4.00, or 8%. Yet the market didn’t suddenly rally to cheer the newfound
“earnings,” so I don’t see why the market should penalize tech stocks for the
new “expense” which in no way affects the intrinsic value of a company.
As for
backdating, I realize from a PR-standpoint the scandals don’t help things, but
if you accept that executives are in a market position to demand a certain
amount of pay, then it is in shareholders’ interest for that expense to be met
in the most tax-efficient manner, and that means stock options. If companies
were forced to give less in the form of stock options and more in straight
salary, it would result in higher taxes—and that comes out of shareholder’s
pockets too!
Q:
What specific S&P industry sectors look good
right now?
MK:I like the Financials (XLF) and
Energy (XLE) Select Sector SPDRs. There could be a lot of upside to estimates
for Financials, because the M&A boom is likely to roll on but the giant fees
Wall Street receives from these transactions are not fully factored into to
expectations yet. As for Energy, although I have no crystal ball for oil prices
the sector looks cheap based on average profitability through the cycle,
not just the current boom earnings.
I would
stay away from Consumer Discretionary (XLY), not because I am bearish on the
U.S. consumer but because the current estimates for more than 10% earnings
growth this year still appear too optimistic. Further, the sector trades at
19.2x those rosy figures, which is even more expensive than the Technology
sector (XLK)!
Q:
What's your take on the sell-off in emerging
market stocks?
MK:
Overdone. To be sure, the iShares FTSE/Xinhua China 25 (FXI) fund is fairly
expensive for a developing market, and remains so after the plunge, but not
egregiously so. FXI now trades at 16.6x 2007E EPS, compared with 12.3x for the
iShares MSCI Emerging Markets fund (EEM), and 15.1x for the S&P 500 SPDR (SPY).
But note
also that EEM was down 8.1% during the meltdown despite the fact that Chinese
stocks make up only about 13% of assets, and even though the stocks which
dominate the index are more exposed to the U.S. economy rather than the
Chinese—implying, therefore, that last week's action might have been an
over-reaction.
I am
advising my clients not to abandon emerging markets, but if they must play China
the better way to do it is through the iShares MSCI Taiwan fund (EWT), on the
basis that FXI is in fact much more leveraged to China’s domestic
economy, while the Taiwan fund is full of companies manufacturing in China for
export, and hence are more leveraged to China’s emergence as the world’s
factory floor.
