Value Investors - The Pendulum will swing back in favour

A recent blog posting over at Morningstar sniped at Professor Jeremy Seigel of Wisdom Tree, indicating that his firm's stock selection methodology and retention of assets depended on his call that a market bottom had been hit.

The post compared the performance of several Wisdom Tree ETFs to various total market benchmarks, showing relative YTD performance is lagging for Wisdom Tree dividend selection process. While true, it ignores the beating that all value benchmarks have taken since the credit crisis began in the summer of 2007.

As most value investors know, they aren't going to beat the benchmark every year - but it's going to happen often enough to outpace "growth" funds by about 2% annually over the long haul.

What's been unusual about this bear market is that it's the so-called value stocks leading the slump, whereas value stocks almost always outperform in weak markets.

Obviously, in this case, that's because the fact is that so many stocks that are usually labelled as value stocks, due to either low PE ratios, or relatively high dividend yields, have found themselves trashed and tarnished by the credit problems. That's because financial firms (whether retail or investment banks, stockbrokers and insurers), which usually have relatively low PE ratios and relatively high dividend yields - putting them squarely in the value camp - have been the epicenter of the credit and economic problems. Wisdom Tree's dividend selection process obviously weights orients a portfolio towards a value selection.

Comparing other value ETFs against growth ETFs show that this phenomenon isn't restricted to Wisdom Tree selections.

For instance, since just before the credit crisis began (I am using June 1 2007 as the date), the Barclays iShares products tracking growth or value indices show the following divergences:

- For international stocks, the MSCI EAFE (Europe, Australia, Far East)iShares index-tracking products shows that the growth product (EFG) has lost -13.2% of its value, compared to much larger -25.3% loss for the value product (EFV). In that context, Wisdom Tree's International Dividend Top 100 EFT (DOO) loss of -16.6% is pretty good.

- For large cap domestic stocks, the iShares growth product (IVW) has lost just -9.0%, while the value product (IVE) has lost -20.8% of it's value. Again, in that context, the Wisdom Tree Large Cap Domestic ETF (DLN) loss of -19.8% is understandable.

- Finally, for domestic small cap, the iShares growth product (IWO) lost 6.5%, while the value ETF (IWN) lost -17.2%. Here, the Wisdom Tree loss is larger at -23.2%.

Given that growth rarely outperforms value for any stretch of time, I believe that the relative outperformance of value must be just around the corner.

In summary, I'd suggest to all value investors in general, and Wisdom Tree ETF holders in particular, to hang on. Retail investors are notorious for dumping underperforming funds, not long before the corner is turned. Don't be one of those fools.



JW

The Confused Capitalist

Emerging Markets Choices

Recently, some members of the investment business have suggested that emerging markets offer unusually good value.

This, of course, offers me the opportunity to once again explore one of my favorite topics.

According to one recent article, despite the growth of emerging markets to currently represent 13% of the world stock market capitalization, British investors have only 1.6% of assets in those markets. Presumably, American and Canadian investors are in the same boat.

This is all the more alarming given that these markets are widely forecast to achieve 50% of the world economy in 20-30 years time. That means that most investors aren't playing the largest visible theme of our times.

Given the growth in ETF's and mutual funds catering to this segment, there's no excuse for most stock investors with a 10-15 time horizon not to be in this market. This is a growth component that simply must not be ignored.

Having said that, I'd like to take a look at two of the most popular emerging market ETF market-capitalization choices, plus three ETF choices from purveyors who use a rules-based fundamental analysis to choose an emerging market basket.

The first two are choices from Barclay's iShares (EEM) and Vanguard (VWO). They are based on selecting on tracking broad-based market-capitalization based indexes. Market capitalization indexes (such as the S&P 500, MSCI EAFE, etc.) select the largest companies by market capitalization for inclusion into the index.

Critics argue that these type of indexes over represent over-valued companies, and under represent undervalued companies, and investors therefore leave some potential alpha on the table, while attracting unwanted volatility. On the other hand, supporters of these indexes argue that, despite these flaws, owning such an index proxy is still a reasonable way to participate in most of the stock markets gains, in a tax and cost efficient manner.

Let's take a look under the hood of both of these choices.

Firstly, cost and turnover. On cost, Vanguard (VWO) has it's legendary cost structure sliced to the bone, with just a 0.25% cost, while the Barclay's product (EEM) has a 0.74% cost. A 0.49% point advantage isn't to be sniffed at, but it't not the only item of consideration. Turnover for VWO is 9% annually, the second highest rate amongst the five products we'll look at. The iShares EEM has a turnover of just 5% annually. In a non tax-deferred account, these two cost and turnover factors are offsetting, with no clear winner. In a tax deferred account, the VWO is the better choice, if these were the only two factors under consideration.

Let's look at the average company size and some of the top sectors in each product. and company size. country choices. In terms of average company size, both are similar with Morningstar defining between 77-80% of the companies held therein as large or giant, and between 18-22% as mid-size. That means either fund has virtually no exposure to small cap stocks, and both can be thought of as large cap ETF's.

In terms of the top four sector allocations, both have financial firms (banks etc.) at between 18-22% of the fund, energy at between 16-20%, and materials between 18-21%. The only difference is for the fourth choice, which for iShares EEM is information technology at 14%, while for Vanguard VWO it is telecommunications at 12%.

In terms of individual stock concentration, the top four choices of EEM comprise some 16.2% of the portfolio value, while for VWO it is 12.2%. The top 20 choices comprise some 40% of the value of EEM, while for VWO it is 27%. EEM holds about 350 securities in total, while it's nearly 900 for VWO.

On these three later factors of market size, sector choice and stock concentration, there isn't that much to choose between these. So let's turn to country selection.

In both ETFs, the top four countries represented in these ETF's are pretty similar, with Brazil in first place representing 16-18%, and either China or South Korea in second or third place between 11-13%. The difference is in fourth place, where Russia represent 11% of EEM, while fourth is held by Taiwan in VWO, again with 11%. Overall, once again, very little to choose from between the two.

Finally, we turn to relative value measures of the portfolio. However, I have to complain about "the people's choice", Vanguard, long a champion of the individual investor. Their disclosure of valuation of the portfolio, in a word, sucks! The only valuation measure they offer is price-to-book (PB) ratio, wherein all of the other choices we'll look at provide at least the price-earnings (PE) ratio and the dividend yield of the portfolio, with some others also providing the price-to-sales (PS) ratio.

Having said that, the PB ratio of VWO is 2.8, compared to 3.7 for EEM. Morningstar calculates the dividend yield at 2.22% for VWO and 2.70% for EEM. Combining these two measures of relative valuation, suggest these portfolios offer relatively similar attractiveness from a valuation standpoint.

Yahoo calculates the PE of EEM at 11.9 (versus iShares own calculation at 18.0), and VWO at 13.0. Given the differences in PE calculations I've seen between Yahoo and ETF providers themselves, I don't think the Yahoo calculations are particularly reliable. On the other hand, Morningstar calculates the cash-flow ratio of both portfolios to be between 8.5 (EEM) to 8.9 (VWO). Therefore, there's little to choose from here, except to say that both portfolios appear relatively expensive, given the valuation characteristics of the three other product choices that I'll cover in a future posting later this week.

And, although no one looks at historical charts - given that we're all aware that past performance is no guarantee of future performance, let's see how the two products have performed against each other and the S&P 500 ETF (SPY) over the past year.



Given the similarity between the products, I'd say it's hard to pick a clear winner. Perhaps if Vanguard would get into the modern era, and provide its investors better information, as well as it's outstanding cost structure, it would be easier to make a choice between these two.

Later this week, I'll look at three fundamental analysis ETF choices.

Disclosure: No positions held.


JW

The Confused Capitalist

Proxy Investing - ETFs

Given what I believe will be phenomenal growth in ETFs over the next decade, particularly those specializing in some sort of fundamentally-based ETFs (or enhanced ETFs), would an investment in Wisdom Tree Investments (the stock) as a purveyor of fundamental ETFs be a wise proxy investment decision?

The industry probably has a huge tailwind, as ETFs generally, and fundamental ETfs in particular, begin rapidly draining money away from both mutual funds and, perhaps, to some extent, individual stocks (which themselves were often previously used as an industry proxy).

Unfortunately, there are no recent SEC filings, so by buying this pink-sheet stock, you're buying a bit of a pig in a poke. Nontheless, given the heavy hitters joing this company (Siegel, Levitt) as owners and advisors, one has to think they wouldn't want to sully their reputation on a business without a viable future. Undoubtedly, provided this stock is at a reasonable valuation now, its return will be a leveraged bet on the ETF market generally.

Value, as always however, remains the key to a decent return.

JW

The Confused Capitalist

A low-maintenance simple portfolio

I am advising an older person on their portfolio allocation for the stock market portion of their investments. Although he's not as old as the still long-term investor, 105 year old Albert Gordon, he's still looking to the future.

And that's smart, because, given his heredity, he may well have another 20-30 years left. And the only thing that'll provide adequate long-term growth over that time, is participation in the markets. I've convinced him that mutual funds aren't the best ticket today, but he still needs broad diversification at his age. So we're looking to some ETFs to fill his ticket.

Readers here know my belief in the power of dividend-paying stocks to produce out-sized market returns, with lower volatility and risk. This has been well-documented in a variety of books, large and small market studies over lengthy periods of time, covering a variety of market conditions. Thus, most of the selections I suggest for this Canadian investor, will fit the mold of having dividend-paying attributes as prime amongst their selection criteria.

Because of potential tax implications, we'll seek suitable Canadian products where available.

We are going to use just four ETFs, a quartet, but this will provide ample diversification by geography and will eliminate individual stock risk. Given that they are ETFs, they will also eliminate so-called "style drift". Finally, we'll use products that use rules-based fundamental indexing where possible, to enhance returns and reduce risk.

Claymore Investments has three of the four products we'll need. Because he's Canadian, it's suitable to try and get returns denominated in Canadian funds if possible, on the basis that cost of living swings might mirror market activity. So here are the products I've suggested:

Claymore Canadian Dividend & Income Achievers (CDZ). Weighted to emphasize stocks that both have a relatively high yield, and also have a good track record of raising their dividends. It tracks the Mergent Canadian Dividend Income and Achievers (fundamental) index. Over the past five years, the index has posted a 15.1% annual gain, versus the S&P/TSX Index return of 11.1% annually. Over ten years, it posted an 18.1% annual return, versus an 11.0% return for the S&P/TSX Index. The underlying holdings are around 55-60 stocks typically. I'm suggesting a 40% weighting for this ETF.

Claymore US Fundamental Index, C$ Hedged (CLU). This ETF also tracks another fundamental index, which tracks the top 1,000 US securities by fundamental value, using the following four factors: cash dividends, free cash-flow, total sales, and book equity. This ETF is also attractive from my point of view, in that I think the US dollar will be lower in 10 years than now, but this ETF hedges against currency changes, meaning that we'll only trap the underlying changes in the index. Over five years, this index has returned a 7.0% rate annually, versus a -3.2% S&P 500 annual return (as converted to Canadian currency). The underlying holdings are around 1,000 stocks. I am suggesting a 20% weighting for this ETF.

Claymore BRIC (CBQ) is the final Claymore product, that portfolio manager Roger Nusbaum has also written about. This ETF isn't fundamentally indexed, but is designed to mirror the BNY BRIC Index, which tracks ADRs from Brazil, Russia, India and China, all powerful emerging economies. Over time, this should be a strong growth component, but one which will also be volatile in nature. This index has returned 33.2% annually over the past four years, versus the more widely known MSCI EM Index, which has returned 19.7% annually over the same period. The ETF has 75 underlying stocks with above average concentration in the first ten stocks, with about 53% of the value held therein. This isn't currency hedged or denominated in Canadian dollars, but this could be a plus if these currencies gain strength against the Canadian dollar over the next decade. I am suggesting a 20% weighting for this ETF.

Finally, for the fourth ETF, I'll suggest a product that trades on the American exchanges, a Wisdom Tree ETF product that tracks the Wisdom Tree International Dividend Top 100 Index (DOO). This is also a fundamental index, based on dividend yield of large and mega cap international companies. Currently, about 80% of the companies in the index are domiciled in Europe, with about 20% in Australia, Singapore and Hong Kong. The index has returned 16% annually over the past five years, as denominated in US Dollars. Conversion to Canadian currency over that time would have considerably diminished these returns to about 8.5% annually (which is still respectable, although not outstanding). While the currency issue may be slightly negative over the next decade, I don't think it's going to weigh down returns like it did over the past five years, or like it might for an unhedged US stock situation going forward. I am suggesting a 20% weighting in this ETF.

Well, that's it. A relatively simple portfolio, with ample geographic representation, and wide corporate representation. The one noteworthy thing about this portfolio is that it's definitely weighted to the financial sector, but I've never considered that a particular problem, since I consider this sector as the backbone of the entire economic system. My theory here is that if this sector suffers some sort of serious long-term decline, so will virtually every other sector of the economy.

Finally, the other noteworthy aspect is the ability of high-dividend paying stocks to resist market downturns, something that might make this particular portfolio even more attractive; certainly, it makes it easier to sleep at night.

In summary, I consider that these four components will produce robust and relatively reliable returns over the medium to long haul, all with overall reduced risk because of the weighting towards the various fundamental indexes.



JW

The Confused Capitalist