Techs Look Solid, But Banks a Bust

05/30/2011 10:00 am EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Large-cap titans geared to global growth are reasonably priced, while banks face another hit from falling home prices, write Paul Justice and Michael Rawson in Morningstar ETFInvestor .

Perhaps our highest-conviction holdings are the Vanguard Mega Cap 300 Value Index ETF (MGV), Industrial Select Sector SPDR (XLI), and Vanguard Information Technology ETF (VGT).

Large- and mega-cap value stocks are selling for 92% of Morningstar’s fair-value estimates, compared with 95% for the S&P 500 and an overvalued 107% for the S&P Midcap 400. The potential return for higher-beta small-cap stocks does not justify the additional risk.

When we bought XLI two months ago, we noted that each of the top holdings sold for an attractive-price/fair-value multiple except for Caterpillar (CAT), which appeared expensive. However, Morningstar’s equity analyst on CAT recently increased his fair-value estimate, based on stronger than expected growth.

High commodities prices and a weak dollar are spurring demand for equipment from overseas energy and mining companies.

Our rationale for buying VGT, the technology ETF, was based on a growth-at-a-reasonable-price strategy. The tech stocks in the Technology Select Sector SPDR (XLK) sell at a price/earnings ratio of about 17, compared with 16 for the S&P 500.

However, tech stocks have year-over-year sales growth of 8% and cash-flow growth of 13%, compared with 1% and 3% for S&P 500 companies.

Microsoft (MSFT) sells at a price/earnings ratio of just 9 and a price/cash flow of 8. Meanwhile, Procter & Gamble (PG) sells at a multiple of 15, and is facing margin compression due to rising commodities prices.

One holding we are concerned about—and would be more inclined to sell when we find better opportunities—is the SPDR KBW Bank ETF (KBE).

When we first bought KBE in mid-December, the market was in the midst of a strong rally based on improving economic data. Bank balance sheets were improving and valuations looked attractive.

While the economic recovery is still on track, we have been disappointed with the acceleration in the decline in housing prices. A large share of the recent surge in bank earnings has come from a reduction in loan-loss reserves, which might swing the other way given these new house-price declines.

In addition, while we had hoped that loan growth was going to accelerate, that has not happened, despite the improving economy. When we see an attractive opportunity, we will likely dump KBE, unless fundamental factors improve rapidly.

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