Using ETFs To Pick Stocks

1/23/2012


Ten years ago, investors interested in U.S. exchange-traded funds had about 100 choices. Now they have more than 1,160 options.

ETFs continue to gain popularity with investors seeking an alternative to open-end mutual funds, which trade once a day and can require buyers to open a separate account with a fund company. Since ETFs trade like stocks, investors can buy and sell them through any brokerage. In addition, most ETFs track stock indexes, and their management fees are generally lower than those of traditional mutual funds.


EXCHANGE-TRADED FUNDS PROLIFERATE

By our count, there were 1,163 U.S. exchange-traded funds (ETFs) at the end of 2011, more than triple
the number five years ago and more than 10 times the count 10 years ago. Last year, a record 228 ETFs
launched. Our data excludes ETFs that have closed.

No. of U.S.
ETFs launched
annually
1993
1
1994
0
1995
1
1996
17
1997
0
1998
10
1999
1
2000
45
2001
22
2002
10
2003
12
2004
34
2005
49
2006
132
2007
197
2008
124
2009
111
2010
169
2011
228

These days you can find ETFs for just about every corner of the market, including sector funds. While the Forecasts prefers to focus on individual stocks, we understand the appeal of ETFs and the role they play in portfolios.

Also, by drawing on our Quadrix stock-rating system, we found another use for ETFs — helping us identify the best market niches for stock selection. Of course, you can find good stocks all over the market. But we prefer to target areas where the best possibilities are concentrated.

ETF CLASS ANALYSIS
We looked at the holdings of 365 U.S. stock exchange-traded funds (ETFs) and discovered that large-cap funds tend to have a higher proportion of their assets in stocks with high Quadrix Overall scores than do funds containing smaller stocks. Within market-cap groupings, growth funds tend to look better. For each category and sector, we provided the ticker symbol of an ETF that looks attractive based on Overall scores.
------------------------------- Quadrix Scores -------------------------------
% Of Assets With
----- Quadrix Overall -----
Avg.
Exp.
Ratio
(%)
ETF Category
(No. Of Funds)
Momen-
tum
Value
Quality
Fin'l
Str.
Earns.
Ests.
Perfor-
mance
Overall
Above
90
(%)
Above
80
(%)
Below
20
(%)
ETF
Ticker
Large Growth (27)
63
51
79
69
49
63
71
22.5
42.7
2.2
0.39
VOOG
Large Blend (44)
55
58
68
64
45
65
67
17.9
35.6
2.5
0.31
VIG
Large Value (35)
50
62
59
59
42
66
63
14.0
29.4
2.4
0.37
DHS
Midcap Growth (14)
64
45
75
62
52
60
66
12.2
33.2
3.6
0.43
RFG
Midcap Blend (23)
56
52
62
56
48
58
59
9.9
25.6
6.6
0.38
JKG
Midcap Value (15)
49
58
51
47
45
58
54
6.5
18.5
7.1
0.38
DVY
Small Growth (16)
57
40
67
60
51
57
56
11.0
25.3
12.3
0.42
RZG
Small Blend (18)
52
49
55
53
50
58
54
9.9
22.1
12.4
0.35
SLY
Small Value (14)
48
53
46
46
48
58
50
7.3
16.9
13.8
0.38
IJS
Sector ETFs
Cons. Discret. (14)
59
48
66
53
58
66
64
12.1
34.7
6.5
0.44
XLY
Consumer Staples (8)
52
45
71
54
42
70
58
4.3
21.5
0.8
0.44
XLP
Energy (17)
69
57
62
64
53
62
69
31.9
50.0
8.5
0.47
VDE
Financial (27)
48
63
45
63
40
59
56
8.0
19.8
8.4
0.44
IAT
Health Care (19)
54
49
69
60
52
62
63
11.4
27.4
11.2
0.44
XLV
Industrials (17)
55
57
64
50
50
60
63
8.4
27.1
3.2
0.44
FIL
Materials (8)
59
60
66
52
35
54
63
10.8
27.2
6.4
0.42
IYM
Real Estate (15)
49
22
38
42
45
60
29
0.5
0.8
32.2
0.43
VNQ
Technology (22)
58
54
77
74
48
51
68
20.7
37.7
5.1
0.48
VGT
Telecom (4)
42
51
53
52
31
51
45
3.5
10.4
6.0
0.32
FLQ
Utilities (8)
41
50
46
51
44
69
45
0.8
5.5
2.5
0.40
XLU
Note: Quadrix scores are percentile ranks, with 100 the best.

As shown in the table above, we looked at the holdings of 365 U.S. stock ETFs to assess which contained the highest proportion of strong Quadrix scorers. Based on average Quadrix scores weighted by stocks' market capitalization, we gleaned three key facts:

1) The stocks in large-cap ETFs average higher Overall, Quality, and Financial Strength scores than those in midcap or small-cap ETFs. Large-cap funds also have more of their assets invested in high Quadrix scorers. For example, in the 27 large-cap growth ETFs we analyzed, nearly 43% of assets were in stocks earning Overall scores above 80, with 22% in stocks scoring above 90. Just as importantly, there are few clunkers in the large-cap space, with less than 3% of ETF assets in stocks scoring below 20 Overall.

2) Growth stocks look better than value stocks. Among large-cap ETFs, growth funds averaged higher Momentum, Quality, Financial Strength, and Overall scores than blend funds, which in turn outscored value funds. We saw the same trends among midcap and small-cap funds.

3) Stocks in energy and technology funds average higher Overall scores. These sector funds also have a higher proportion of assets in top scorers. Consumer discretionary, health care, industrials, and materials funds also average at least 27% of their assets in stocks with Overall scores of 80 or higher.

With these findings in mind, we went fishing for the best stocks in industry groups with the largest number of high scorers. The table below lists industry groups with several top Overall scorers and our favorite stocks from those groups. Below we discuss a stock and an ETF from two of those groups.

Technology: data processing

Alliance Data Systems ($108; ADS) grew per-share profits 52% in the 12 months ended September, lifted by sales growth of 19% and sharply higher profit margins. Along the way, the stock topped the profit consensus by an average of 12% in each quarter. Alliance, a provider of marketing and customer-loyalty programs, has a history of strong operating momentum. Over the last five years, the company grew per-share operating profits at an annualized rate of 19%, while cash provided by operations rose at a 29% clip.

Demand for Alliance's marketing services remains strong, with a pickup from consumer-goods, financial, drug, and retail customers. The consensus projects 2012 profit growth of 13% in 2012, yet the stock trades at less than 14 times trailing earnings, a discount of 33% to its own five-year median and 18% to its peer group. Alliance is a Focus List Buy and a Long-Term Buy.

Alliance Data Systems is held in Vanguard Information Technology ($63; VGT). The ETF's component stocks have a weighted-average Overall score of 75, above the category average of 68. The expense ratio is only 0.25%, versus 0.51% for the average tech ETF. We do not recommend this fund, but it compares well to other technology ETFs.

Energy: integrated oil & gas

Chevron's ($107; CVX) cash from operations, up in eight straight quarters, surged 39% in the first nine months of 2011 to $32.03 billion — setting a record annual high even before including results for the December quarter. Earlier this month, Chevron warned that December-quarter profits would lag September-quarter profits because of a decline in refinery production.

However, the consensus already projects a 24% sequential earnings decline. Chevron expects upstream earnings to match September-quarter results. For 2012, Chevron shares could be supported by robust oil prices, projected to remain above $100 a barrel. While the warning could weigh on the shares in the near term, the Focus List Buy's fundamentals remain solid.

Components of Vanguard Energy Sector ETF ($102; VDE) have a weighted average Overall score of 77, and 66% of the fund's assets are in stocks scoring above 80. Chevron is the fund's second-largest holding. The fund's expense ratio is a tiny 0.19%. We do not recommend Vanguard Energy Sector, but it compares well to other energy ETFs.

SCREEN OF THE MONTH: TOP STOCKS IN TOP GROUPS
Industry Group (No. Of Stocks)
Avg.
Quadrix
Overall
Score
No. Of
Stocks
With
Overall
Above 90
% Of
Stocks
With Overall
Above 90
No. Of
Stocks
With
Overall
Above 80
% Of
Stocks
With Overall
Above 80
Apparel (39)
54
4
10
9
23
Banks (21)
77
8
38
10
48
Casinos/Gaming Equipment (30)
57
5
17
8
27
Chemicals — Agricultural (14)
79
8
57
10
71
Chemicals — Specialty (42)
62
6
14
11
26
Construction/Farm Equip. (42)
63
13
31
17
41
Consumer Finance (22)
76
8
36
14
64
Electrical Comp. & Equip. (53)
53
8
15
13
25
Electronic Equipment Mfgrs. (45)
52
7
16
12
27
Gold (48)
44
13
27
14
29
Industrial Distributors (35)
65
5
14
13
37
Industrial Machinery (81)
61
10
13
24
30
Integrated Oil & Gas (25)
79
10
40
16
64
IT Consulting & Services (40)
58
4
10
10
25
Life & Health Insurance (26)
67
4
15
9
35
Managed Care (15)
78
5
33
8
53
Metals/Mining (44)
45
7
16
12
27
Oil & Gas Equipment & Svcs. (57)
52
10
18
14
25
Oil & Gas Refining (25)
59
5
20
9
36
Outsourced Data Processing (47)
63
6
13
15
32
Semiconductor Equipment (45)
67
15
33
22
49
Services — Education (22)
69
6
27
9
41
Steel (35)
66
10
29
12
34
Technology Distributors (16)
68
3
19
8
50
Above we list 24 industry groups containing at least eight stocks with Quadrix Overall scores above 80. Below, we present 27 A-rated stocks from those groups. Stocks recommended for purchase are listed in green.
------- Quadrix Scores -------
Company (Price; Ticker)
Momen-
tum
Value
Overall
Industry
U.S. Bancorp ($29; USB)
88
69
92
Banks
CF Industries ($173; CF)
99
92
100
Chemicals — Agricultural
AGCO ($50; AGCO)
97
86
99
Construction/Farm Equip.
Caterpillar ($103; CAT)
94
70
95
Construction/Farm Equip.
Deere ($85; DE)
87
66
94
Construction/Farm Equip.
American Express ($50; AXP)
70
74
87
Consumer Finance
Barrick Gold ($48; ABX)
93
69
97

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