What you need to know about investing in value ETFs

ETF is the acronym for Exchange Traded Fund. To put it simply, it’s a fund that is traded on an exchange. 

The fund can be composed of stocks, bonds, commodities or anything else aggregated into one basket of securities. The fund can be a variety of stocks crossing many fields, it can be based on a specific index, or it can be stocks concentrated in a certain sector such as energy, real estate, or health care, to name a few.  

ETFs are traded on exchanges all over the world, and they trade like a stock. Similar to a stock, an ETF has a ticker label, and can be purchased and sold throughout the day like any other stock.

There are around approximately 7600 current ETFs, with around 2200 based in the US.

Your capital is at risk.

What is value investing?

Value investing is a strategy where a person seeks to invest in companies available on the market at a price that is lower than their intrinsic value. Intrinsic value is calculated as the value of the total cash flow the company will produce over its lifetime discounted at a reasonable rate. When the price gap is wide then a “margin of safety” exists, which reduces the risk of permanent capital loss. Usually, the margin of safety will be with companies trading at a lower multiple, i.e. P/E, P/S/ P/B, and high ROIC. 

Value ETFs

Value ETFs look mainly to invest in a group of companies believed to be undervalued as to their real market value. Contrast this with growth ETFs which seek to invest in companies expected to grow at a quicker rate in comparison to the overall stock market. Investors hope that both value and growth ETFs will yield above-average returns. The decision to choose one over the other is largely a function of investment goals, risk tolerances, and the current status of an investment portfolio.

For example, if a person can stomach fluctuation and market volatility, then a growth ETF may be right for him, but if the person prefers a more conservative investment, then a value ETF can be the right way. 

Value ETFs provide long-term growth and also dividends. The dividend yields on value ETFs can become a steady, predictable income that can become a large part of the value ETF’s shareholder return. 

Identifying a value investment

There are a few general criteria that investors use to find a value investment.

Price-to-Earnings Ratio: Also known as the P/E ratio, this metric helps investors determine the relative value of a stock. The formula is to divide the current share price by earnings per share. For example, if the price per share is $30 and the earnings per share are $3, the ratio is 10. A lower ratio usually indicates a more undervalued stock. 

Price-to-Book Ratio: This ratio divides a stock’s current share price by its book value per share to determine whether the stock is over or undervalued. The book value of a company is determined by subtracting the total liabilities from the total assets. Book value is a more conservative estimate of the company’s value as opposed to market value which is determined by how much investors are willing to pay for a stock now based on the expected future earnings of the company. 

If the price to book ratio is around 1, that means the specific stock is trading close to book value. A ratio of 0.5, however, would be attractive to a value investor as it indicates that the market value of the specific stock is trading at less than its book value.

Debt-to-Equity Ratio: This metric explains how the company is financing itself. Is the majority of its capital coming from debt or shareholder equity?

An example of this ratio would be a company whose debt is $70 million and equity is $150 million. The ratio here would be 0.47, meaning that for every dollar of equity there are 47 cents of debt. Whether a higher or lower ratio is good can vary depending on the industry.

Dividend Yields: This metric shows the amount of dividends an investor would receive annually from the company expressed as a percentage rate. The formula is an annual dividend, divided by the current stock price and then multiplied by 100. A higher dividend yield means the investor receives higher dividends from the company for less money.

An example of this would be a stock trading for $80 whose annual dividend is $4 per share. After dividing the dividend by the share price and multiplying by 100 we get a dividend yield of 5%, which is considered to be pretty good. 

Free Cash Flow: This is the cash a company has on hand after it pays its operating expenses and capital expenditures.

While all these metrics can help to find value stocks, they don’t guarantee the investment will be successful.

Advantages of ETF investing

Some of the benefits of investing in ETFs are as follows:

Diversification: ETFs are a basket of assets allowing a person to diversify their investments easily and is advantageous to purchasing an individual stock where the investor is putting all their eggs in one basket.

Time-Saving: Though an individual investor can diversify their investments, similar to an ETF, that person will be required to purchase each stock by itself, whereas via an ETF the whole basket is purchased at once.

Cost: ETFs allow an investor to own many securities at a fraction of what it would cost to buy each stock by itself. This means for a small price, an investor has positions in many companies. This differs from a mutual fund which usually has a minimum investment required, which can be hundreds or thousands of dollars. Take, for example, a mutual fund that requires a $2000 minimum investment. For the same price, as will be seen below, you could buy almost 30 shares of the iShares Core S&P Value ETF which sells for around $70 a share.

Transparency: In ETFs, the investor knows exactly what is happening at all times, whereas in a mutual fund earnings are only announced periodically. 

Can Be Purchased Like A Stock: You can purchase throughout the day and know the exact purchase price. You can also execute more sophisticated trades. This, as opposed to a mutual fund, where there is only one price throughout the day regardless of when the purchase is made.

Professional Management: Instead of spending time researching companies, reading articles and recommendations as to what stock to buy, here a professional fund manager will pick the stocks, saving you time and effort. This professional’s job is specifically to decide which securities will be in the fund.

Examples of value ETFs

A few examples of ETFs from Vanguard include the Vanguard Value ETF which is based on the Vanguard Value Index Fund that uses an indexing investment approach created to track the performance of the CRSP US Large Cap Value Index. This index is composed of value stocks, mainly of large US companies.

The Vanguard Small-Cap Value ETF is based on the Vanguard Small-Cap Value Index Fund which tracks the performance of the CRSP US Small Cap Value Index, including a range of stocks of smaller US companies. The fund seeks to replicate the aforementioned index by investing in a majority of stocks on the target index and giving each the same proportional weight it has on the index.

The Vanguard S&P 500 Value ETF invests in the stocks in the SPX500 Value Index which is made up of the companies in the SPX500. 

Some other ETFs based on indices are iShares’ Russell 1000 Value ETF based on the Russell 1000 index, which is made up of mid and large-cap companies. The top three holdings in the fund currently are Berkshire Hathaway, JP Morgan Chase, and JNJ. iShares’ Russell 2000 Value ETF is based on the Russell 2000 index whose assets are small-cap and the top three holdings currently are Darling Ingredients, GameStop, and Cleveland Cliffs. In both cases around 50% of the assets come from the financial, industrial and healthcare sectors, and each is selling in the area of $150 per share.

Two specifically mid-cap ETFs are iShares’ Russell Mid-Cap Value ETF based on the Russell MidCap Value Index, and S&P Mid-Cap 400 Value ETF based on the S&P Mid-Cap 400. Both are selling in the area of $105 per share and their top asset sectors were financial, industrial and consumer discretionary. In the former, the top three holdings currently are Twitter, Freeport Mcmoran and Ford, and the latter had East West Bancorp, Steel Dynamics and Owens Corning.

One ETF including all sizes of companies is iShares’ Core S&P US Value ETF based on the S&P 900 Value Index and is currently selling for approximately $70 per share. The top three holdings were Berkshire Hathaway, JP Morgan and Walt Disney. Here the top 10 holdings and the general asset sector breakdown were similar to the Russell 1000 Value ETF.

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