A couple weeks ago we received an e-mail from Morningstar announcing a new type of ETF research. Here's a key passage from Morningstar's Jeffrey Ptak:
Our new Analyst Reports mark a novel approach to evaluating ETFs. We're harnessing the research that our 100-plus equity analysts conduct in order to estimate the fair value of stock ETFs.
By comparing our fair value estimate for an ETF's portfolio with the fund's market price, we can better gauge whether an ETF is cheap, dear, or reasonably priced. In so doing, we can help you profit from inviting opportunities as they arise.
Our ETF fair value estimates are based on our stock analysts' rigorous, bottom-up research. Our analysts are digging into company filings, questioning management, conferring with suppliers and competitors, and creating sophisticated financial models--all to estimate each firm's worth and risk. And they are conducting that research in accordance with a disciplined, consistently applied investment philosophy.
We think this is a vastly superior approach to the breathless macro-economic calls, technical analysis, or short-cut methods that often pass for fundamental analysis.
Vastly superior? That claim strikes us as a bit inflated. We make no case for breathlessness, of course, but we do think there's a...er...fundamental problem with this kind of "fair value" analysis. As ever, equity prices are functions of (more or less*) objective facts (earnings, revenue, margins, &c.) and investors' entirely subjective willingness to pay for such things. So not only are "future facts" difficult to project with precision, but who can say what traders and investors will pay for them?
Given this two-dimensional uncertainty, we think estimates of fair value--over what time frame? in what sort of broad market conditions? assuming current industry trends persist? or that they change?--are surrounded by such enormous error terms that they might more profitably be ignored than followed.
But if not estimates of fair value, if one doesn't have a "price target" for a given security or, in turn, a pool of securities such as an ETF, what's left? We'd say known fundamentals (i.e., recent "facts") and current price and volume action are the only serviceable sources of advantage in our relatively efficient, hyper-competitive, often random financial markets.
Now, this is a little too easy, but we can't resist. In a piece accompanying the item from which we pulled the above exceprt, Ptak concludes with this:
For example, as of this writing, we'd expect Financial Select SPDR (XLF) to generate a 22.4% annualized return based on a comparison of the fund's price to our estimate of its intrinsic worth. That ETF's hurdle rate is roughly 14% (sum of the fund's 10.8% cost of equity, 0.24% annual expense ratio, and an approximate 3% incremental risk premium). Given that the fund's 8.4% risk-adjusted excess return--22.4% expected return less its 14% hurdle rate--is greater than 3%, we're currently recommending it.
On February 27th, XLF closed at $27.56. At last check today it was changing hands at $24.23, a decline of 12.1% in two weeks. Which means that it'll have to gain 39.2% from here to reach Morningstar's "fair value" estimate of $33.73 in the next 50 weeks. We'd say that's possible. And exceedingly unlikely.
* Yes, these "facts" can be fudged. And sometimes are. But let's just assume for the sake of this discussion that earnings are earnings.