Buying Value In ETFs Amidst a Beaten-Down Technology Sector

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Yes, the Nasdaq market is down, but here's the multi-trillion dollar question: Is the market down enough? Since its high early in 2000, the Nasdaq 100 Index is down about 50%. Is this correction enough justification for the cuts in sales and estimated earnings by the major technology companies?

The Technology Sector Correlation Wreckage

The correction in tech has impacted virtually all growth portfolios. Diane Garnick, Equity Derivative Strategist at Merrill Lynch, points out that the tech decline has also significantly impacted all of the U.S. equity indices.

Tech weighting in the S&P 500 has gone from 34% in August 2000 to about 24% in early 2001 as a result of the decline in the stocks of this sector.

A comparison might be made with the present tech sector and the energy sector in the late 1970s. The energy sector then was an important weighting in the S&P 500. "The energy sector weighted then much as the tech sector does today," Garnick says. "If you were to think about the importance of energy in the late 1970s, that is sort of the way tech is today."

Over the last year, 55 additions were made to the S&P 500 - 20 of those additions were from the tech sector. Without these additions, tech would be weighted in the S&P 500 at only about 20%.

The Technology Sector SPDR (XLK)

Because of the tech decline, the multiples of this sector are much more reasonable. In our [East/West Securities] view, the sector can now be bought for appreciation. SPDR Technology (XLK) is presently selling at a multiple of 30 times future earnings. This is a significantly lower multiple than XLK sold for several months ago.

In fact, many companies have come down so far in price that they are now measured on a value basis rather than a growth basis. "Nortel, JDS Uniphase, Agilent, these are companies that are thought of as growth companies," Garnick says. But these companies will now be value companies.

Garnick says that this move will allow a number of traditional value companies to switch to growth. "Predominately financial companies, like American International Group, The Bank of New York, State Street Bank and others, were usually thought of as value, and will now move over to the growth indices," she says.

In fact, if AT&T did not reduce its dividend so significantly, the growth indexes might have a higher yield than the value indexes.

More investors are using exchange-traded funds (ETFs) as a way to get low cost and effective participation in sectors. Garnick points out that "on December 22, 2000, the dollar volume in XLK was $1.8 billion, which is very high. People are using that sector ETF to quickly access the technology portion of the US equity market."

XLK: A Reasonable Multiple

XLK is at a bargain multiple, especially when compared to other growth ETFs. For example, the Nasdaq 100 ETF (QQQ) is 128 times earnings, still a steep valuation.

Also, when you consider that SPY is 22 times earnings, XLK, being a 100% technology based sector, seems a rather modest multiple in light of its potential future growth.

Of course, this is not to say that buying XLK is a lock on growth, but if tech does rebound and grow again, one can buy this potential growth through XLK at a multiple that won't make your nose bleed.

SPDR 500 (SPY) and the Mid-Cap 400 Index ETF (MDY)

Sam Stovall, Senior Investment Strategist for Standard & Poor's (S&P), feels that the Mid-Cap SPDR (MDY), which is based on the S&P 400, will be a good investment in the year 2001. And he makes the case that 2000 was a good year also: MDY was up over 11% for the year. A good performance, especially when you consider that SPDR 500 (SPY) was down about 11% in the same timeframe.

"It looks as if investors are gravitating more toward the mid-caps, not necessarily toward the small-caps," Stovall says. "Small-caps were up about 4.5% in 2000, still a positive performance, but only about a third of the mid-cap's performance."

Stovall thinks that valuations will create the mid-cap success. He points out that the price/earnings (p/e) on projected 12-month earnings for SPY is 22 times, whereas MDY for the same time period is only 17 times, a good discount.

Also, the price earnings to the projected five-year growth rate is very attractive in MDY versus SPY. Many analysts today use a p/e to growth ratio (PEG). Using this ratio allows one to measure a company's p/e in line with its growth. 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, 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.

The PEG ratio is 0.9 for MDY, versus a ratio of 1.3 for SPY.

Stocks in the Indexes

MDY is heavy in tech stocks, as is SPY. MDY is about 22% tech-weighted, and SPY is about 24%. The reason for the heavy concentration in tech in these indexes is not caused by S&P predicting that these sectors will outperform - rather, the heavy tech concentration occurs as a result of S&P choosing the companies and sectors which are reflective of the overall market composition.

To keep the indexes current to the overall market, S&P screens 10,000 stocks on a consistent basis.

Often I hear market participants saying, "If only I knew the stocks that were going to be moved up into SPY. Those stocks are bound to move. I'd load up on them."

Well, the best way to get into a position to have pre-SPY selected stocks is to buy MDY. "One of the first places that people on our index committee look for replacement stocks is in the Mid-Cap 400," Stovall asserts. "So a company that is tapped to be added to SPY, if it is going to see price appreciation by people buying in advance of the companies being put into SPY, that will benefit MDY."

Stovall also points out that in the consumer cyclical sector there is a big difference between SPY and MDY. In SPY the sector represents 7.1%, but in MDY the sector comprises 13.8%. This sector includes retail and like groups. These groups are interest sensitive and consumer discretionary related. So if consumer spending picks up this sector will do well, and this success will be more represented in MDY than SPY.


This article contains excerpts of an article that originally appeared in the February 2001 edition of East/West Speaks, a publication by East/West Securities, and is reprinted with permission.

Max Isaacman is a registered investment advisor at East/West Securities
in San Francisco. He is also the author of the book 'How To Be an Index Investor,' which was published by McGraw-Hill in May 2000.