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We recently made some exciting changes to our research on exchange-traded funds. We've written at length about our approach to ETF research, what makes it different and how investors can benefit from it.
But sometimes a picture -- or, in this case, a sample analyst report -- is worth a thousand words.
Wall Street -- that is, the nameplate banks, brokerage houses, exchanges and specialists that constitute the financial world's nerve center -- has gotten rocked recently.
Bear Stearns (BSC, news, msgs) imploded amid vanishing confidence in its ability to make markets. The big brokerages such as Merrill Lynch (MER, news, msgs) and Morgan Stanley (MS, news, msgs) have been laid low by massive write-offs. Lehman Bros. (LEH, news, msgs) recently had to raise $4 billion in capital in order to allay fears that it would be the next domino to fall.
And that's to say nothing of E*Trade Financial (ETFC, news, msgs), which nearly collapsed, or the other capital-markets-dependent businesses -- Chicago Mercantile Exchange (CME, news, msgs) and NYSE Euronext (NYX, news, msgs) -- that have gotten caught in the downdraft. There's blood, as they say, on The Street.
The recent performance of the iShares Dow Jones US Broker-Dealers (IAI, news, msgs) ETF, which invests in many of these names, well attests to this. The fund suffered a 27% loss in the first quarter and is down nearly 28% for the past year through April 10.
Yet, if fear, to borrow the hoary saying, is the surest sign of a buying opportunity, are these stocks a screaming buy?
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Granted, we consider our fair-value estimates on a number of these companies to be uncertain, not least because of the opaque nature of the businesses and their financial reporting. We're also keenly aware that other disasters could loom on the horizon. But would a fund like iShares Dow Jones U.S. Broker-Dealers diffuse those risks to the point that the group is a bargain as a whole?
My colleague Emiko Kurotsu recently took a whack at answering that question in her analysis of the iShares fund. That report is below.
iShares ETF analysis
- Rating and data: as of April 4.
- Valuation rating: fairly valued.
- ETF market price: $40.25.
- ETF fair-value estimate: $47.82.
- ETF expected return: 18.4% annualized (three-year time horizon).
- Analyst's note: April 3.
IShares Dow Jones US Broker-Dealers is risky. The fund invests in the shares of capital-markets companies that make markets in securities, trade for their own account or put together deals such as mergers and securities offerings.
Prominent examples include nameplate investment banks, retail brokerages and exchanges like NYSE Euronext. Confidence is the lifeblood of these businesses. When it wanes, these businesses can fail. Further, given the level of interconnectedness in the capital markets, no company is an island.
Thus, the failure of one company can ripple throughout the financial system, meaning that investors here court not just company-specific risk but also a degree of systemic risk.
Given the preceding, we'd invest here only at a healthy margin of safety: The ETF would have to trade at least 20% below our fair-value estimate before we'd recommend it.
Although the investment banks and brokerage houses have gotten battered recently in the wake of Bear Stearns' implosion and continued fallout from the subprime-lending crisis, they're still not quite cheap enough for our liking. This portfolio was trading at a 15% discount to our fair-value estimate as of April 2.
That said, it's worth noting that our fair-value estimates on a number of the ETF's exchange, brokerage and specialist holdings remained under review as of this writing.
Because we assume that under-review stocks are trading at fair value, these stocks -- which recently soaked up around 28% of the fund's assets -- depress the portfolio's fair-value estimate (assuming they're trading at discounts to our fair-value estimate, that is).
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If we limited our scope solely to stocks carrying active fair-value estimates, those names were trading at a roughly 23% discount to what we think they're worth in the aggregate as of April 2. The fund's top four holdings -- Morgan Stanley, Goldman Sachs (GS, news, msgs), Merrill Lynch and Lehman Bros. -- were trading at 23%, 20%, 30% and 39% discounts to their respective fair-value estimates as of that date, as investors have adopted a sell-first, ask-questions-later mentality in discounting the shares amid continued turbulence and fear in the capital markets.
Thesis as of April 3
IShares Dow Jones US Broker-Dealers weights its 30 or so holdings by market cap, so giants such as Morgan Stanley hold sway atop the portfolio.The "broker-dealers" rubric covers a variety of companies. The fund includes:
- Goldman Sachs and other nameplate investment banks with big trading operations.
- NYSE Euronext and other exchanges.
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