Sub-sector ETF Investing in 2013 - Part 2

by Wayne Ferbert on January 8th, 2013

Today, we are going to look at three very closely watched sub-sectors: Homebuilders, Biotechnology, and Banks. These sub-sectors attract a lot of attention from both long-term investors and short-term speculators.
In our case, we are looking at them for the long-term using our valuation methodology that we introduced when we examined the broad S&P 500 sectors. As a reminder, we examine 4 key traditional valuation metrics: Price to Earnings, Price to Book Value, Price to Cash Flow, and Price to Sales.
1. Homebuilders sub-sector
Starting with Homebuilders, there are two very large ETFs with over $1.5 billion in AUm in each. They are the XHB (SPDR S&P Homebuilders) and the ITB (iShares Dow Jones US Home Construction). The XHB is designed to be more broadly spread out over BOTH companies that sell homes and companies that benefit from home construction. The latter category includes firms like Mohawk, Sherwinn Williams, Standard Pacific, Tempur Pedic, and Lumber Liquidators. These firms benefit from growth in new home sales. The ITB etf also has some of these firms but it is much more heavily weighted at the top to focus on the Home Builders themselves.
It doesn’t matter which ETF you look at in this case, there is not a buying opportunity in this sub-sector right now. Across ALL of the stocks that exist in both of these ETFs that Morningstar rates, only one of them has a buy rating: Bed Bath & Beyond. And when we examine our valuation rankings, we only have one stock with a Buy rating: Whirlpool.
The Homebuilders were among the biggest winners in 2012. Rarely does a sub-sector out-perform two years in a row. Nothing about this sector’s fundamentals or valuation encourage me to buy here. Wait out this sector in 2013 and look for a pull back.
2. Bio-technology sub-sector
The biotech sub-sector is a very closely watched sector – and a very popular sector with more speculative investors. Some of these investors like to look for the next big drug break-through and invest in specific stocks in this sector. We are more interested in whether this sector offers a broad buying opportunity because it trades at a discount.
The best ETF to play in this space is symbol IBB – the iShares NASDAQ Biotechnology fund. It has over $2 billion in AUM. The top 10 stocks in this ETF make up just over 50% of its assets. The next 20 stocks make up only 25%+ of the ETF’s assets. So, these top largest stocks are going to have to be under-valued to represent a good buying opportunity here.
The problem is, we just can’t find it. Among those top 10 stocks, they are ALL rated as Sells by our valuation system. In addition, Morningstar rates 5 of them as Sells and 5 of them as Buys.
The next 20 largest stocks don’t look any better really. We only see one buying opportunity in this next group and it represents less than 1% of the total AUM in the fund. Morningstar only has a Buy rating on two of these top 30 stocks in the ETF.
Interestingly, however, Morningstar has a 4-star BUY rating on the ETF itself. But they place a $138 fair value on the fund and it trades at $143. I think Morningstar will re-visit this valuation soon.
So far, still no sub-sectors worth specific investment capital. Maybe the banks will show up on our radar since the Broader Financial sector is a buy rating.
3. Banks sub-sector
Banks are by far the largest in market capitalization within the Financial sector. So, it would stand to reason that we would likely find value here since we found value in the S&P 500 Financial sector.
The KBE is the SPDR S&P Bank ETF with over $1.6 billion in AUM. This is the most diversified ETF you will ever encounter. There are 40 banks in this ETF. The largest holding (Bank of America – BAC) represents 2.6% of the fund. Meanwhile, the smallest holding (Valley National Bancorp) represents 2.19%. All of the other 38 banks fall somewhere between 2.2% and 2.59% of the total fund.
The fund is intentionally designed this way as an equal weighted fund. There is not one stock that will drive this vehicle. We will look at the ratings on all 40 stocks before we can form a strong opinion on this category since no stock is very large in the total holdings of the fund.
The stocks that are in this fund actually are very strongly rated by both our valuation metrics AND the Morningstar ratings. In our valuation rankings, 20 out of the 40 stocks get a Buy rating. Only 2 of the stocks get a SELL rating leaving the other 18 as Holds. That, in the aggregate, makes this fund a BUY candidate.
Morningstar’s rates 33 of these stocks. Eight of them get a Buy rating as 4 stars (there were no 5-star ratings).  Only one stock gets a sell rating leaving the other 24 as 3-star rated or Holds.
This sector definitely gets consideration as a sub-sector worth investment in 2013. It makes sense given the fact that the Financials sector gets a buy rating in 2013 also and these are the largest players in that sector.
Just note that this is really one of the few ways to play the banking sector alone in an ETF and it is equal weighted fund. As a result, if the sector moves considerably in 2013 because of one or two players (ie, Like BAC in 2012), then you could see significant under- or over-performance in this fund. If the sub-sector goes up broadly, then the fund should move broadly.

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