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Betting on Sector ETFs in a Highly-Valued Market

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As one who sold stocks to investors in the early 1970s, I realize how misleading price/earnings multiples (P/E) can be. Although these multiples have their limitations, P/Es can be useful when making valuations. Still, other valuations should be used in conjunction with P/Es to paint a broader picture.

Even with the current high P/Es and taking other valuations into account, exchange-traded funds (ETFs) should be bought with long-term appreciation in mind. This article will focus specifically on the Standard & Poor's (S&P) 500 (SPY), the S&P MidCap 400 (MDY), and some of the sector SPDRs.

As far as size, S&P considers companies valued at $5.0 billion and larger to be large-cap companies, and therefore suitable for SPY. Small-cap companies are those valued at $1.0 billion and smaller. Mid-cap companies are classified as those somewhere in between.

Of the sector SPDRs, I find the Energy Sector SPDR (XLE), the Financial Sector SPDR (XLF), and, for patient value-oriented investors, the Basic Industries Sector (XLB) to be particularly useful.

Selecting an index that represents the stock market

The S&P 500 provides a broad representation of the stock market. The roots of this index started back in 1928, but the index as we know it today was developed in the late 1950s. At the time it was formulated it was designed to be an all-encompassing benchmark, reflecting the U.S. equities market. The index includes more than 100 industries in 11 economic sectors. The strategists at Standard & Poor's constantly revise the S&P 500 so that it continues to be an accurate representation of the stock market.

When an old-economy company in the index is to be replaced, strategists at S&P do not replace it with a new-economy stock because they think that a hot technology stock has more appreciation potential. S&P is not about guessing which sectors or industries will appreciate the most. There are restrictions on the stocks that S&P can use, and how often changes can be made. This keeps the indexes from becoming too aggressive.

MDY and SPY are a reflection on the domestic markets, and include only companies that are U.S.-based. Also, the companies are required to have sufficient float, so that the funds based on these indexes can invest in the company. To be a part of the index, the company must also experience positive earnings or cash flow. Also, not more than 50 % of the shares of the selected companies can be held by management or insiders. Naturally, these criteria exclude many dot-com companies in the technology sector.

Is the S&P 500 realistically priced?

Some analysts believe SPY is selling at too high a valuation. SPY currently sells at about 25 times forward earnings. This is historically a high P/E, escpecially when considering that for most of the past 25 years the index has had a multiple somewhere in the teens. But this valuation can be justified by changes the index has experienced. One should keep in mind that the multiple is not the only gauge to measure an index's value.

Many analysts today use a P/E to Growth Ratio (PEG). Using this ratio allows one to measure a company's P/E more in line with its growth rate. The mathematical expression of this ratio is given as a variation from 1.0; 1.0 is considered a "fair" value. The lower the number from 1.0, the greater the discount from fair value. As an example of this calculation, suppose that a stock sells at 10 times earnings, and has a 10% earnings per share growth rate - its PEG ratio is 1.0. A stock at 20 times earnings with a 10% earnings growth rate has a 2.0 PEG, twice its fair value.

According to Sam Stovall at S&P, the SPY PEG ratio, calculated to the ETF's projected five-year growth rate, is 1.4 times. This figure does not seem as high in light of SPY's growth bias.

SPY - active growth fund?[/:Author:]
Over the last 36 years, 740 companies have dropped out of the SPY. This is a rate of about 20 companies per year, or roughly 1.5 companies per month. That's a high frequency of change in a portfolio - bordering on active account management.

In a recent report, Douglas Cote at Aeltus Investment Management points out that the trend toward the number of company changes in SPY has accelerated. Cote reports that there were 89 portfolio changes in 1999, and 59 changes from January 1, 2000 through July 27, 2000 - a sharp increase indeed.

Cote points out that the type of company being added to the S&P 500 is changing. The P/E ratios on the added stocks were 108 times earnings, while the P/Es of the dropped stocks were 40 times earnings during that time period. The addition of companies with higher P/Es necessarily creates an increase in the SPY P/E ratios.

So SPY is not a staid, static ETF. And since the ETF does encompass technology (accounting for about 33% of the index), it has a growth bias. The inclusion of so many companies from the tech sector is especially striking when you consider that since 1970, with one exception, no sector has had more than about an 18% weighting in the index. That exception was in 1985, when the Energy sector comprised about 28% of the index.

With the inclusion of technology-sector companies, it stands to reason that SPY's P/E and PEG ratios would be high. But for long-term participation in the U.S. market, SPY is reasonably priced.

MDY - a lower valuation ETF

Usually the smaller-cap, faster-growing stocks sell at a higher valuation than their larger-cap counterparts. But this is not true when MDY is compared to SPY.

The P/E on MDY is about 20 times earnings. This is lower than SPY, even though MDY has a faster growth rate than SPY. Also, the PEG ratio on MDY's projected five-year growth rate is lower than SPY, at 1.0. The ratio of 1.0 is an appraisal that most analysts consider a fairly-valued number.

There are differences in the earnings compositions of these two indexes. About 40% of the earnings from the companies comprising SPY are from foreign sources. Less than 20% of the earnings of MDY companies are generated from non-U.S. sources.

The point could be made that SPY's earnings are more geographically diversified. However, this fact does not present a clear advantage. As companies get bigger and become the size of SPY companies, they have no choice but to compete in the international arena. And international competition is as tough or even tougher than domestic competition.

MDY can be bought for appreciation. Over the next 18 months, I would expect MDY to perform as well as it has the last 12 months, or up about 22%.

Energy - still a good sector buy?

Although the Energy Sector SPDR, XLE, has had a good run, I still consider it a buy at 32. With crude oil selling above $30 a barrel, up from about $11 a barrel just 18 months ago, the increase in oil price does not seem fully reflected in the price of XLE. Oil is up about two and a half times, while XLE is up only about 30%.

Although appreciation of XLE is not expected to keep pace with the increase in the price of oil, it does not seem that XLE is fully discounting the earnings improvement of its constituent companies.

Most of the risk in XLE is centered on the price of oil. If oil comes down, it would affect XLE negatively. However, it is hard to see a sustained drop in oil prices, especially considering that petroleum reserves are at 20-year low levels. Also helping to keep oil prices high is the lack of spare refining capacity. It would be difficult at best to suddenly create substantial additional product to lower prices.

XLE is modestly appraised: the ETF sells at 18 times earnings versus the S&P 500 Index P/E ratio of about 25 times earnings.

Sector SPDR Basic Industries (XLB) - an interesting value play

This sector contains the economy's basic industries - such as gold, paper, and chemicals. Among the sector's chemical companies are the majors: E. I. Dupont de Nemours & Co., Inc. (DD); Alcoa, Inc. (AA); Dow Chemical Company (DOW).

The problem with XLB is that there is no strong earnings momentum in the sector companies going forward. Distressed, cheap sectors can stay distressed and cheap for a very long time - witness the gold sector.

But XLB could be a contrarian play on a P/E multiple basis. According to Kevin McNally of Salomon Smith Barney, the ETF sells at 13.2 times earnings. This is half of the S&P 500 multiple. For patient investors, this ETF is an interesting longer-term play, with limited downside.

10/16/2000

Max Isaacman is the author of How to Be an Index Investor, published by McGraw-Hill. He is a registered investment advisor, associated with East/West Securities in San Francisco. His personal Web page is www.xchangesec.com.