108 Using Exchange-Traded Funds Opportunistically: Getting to Undervalued Stocks
Using Exchange-Traded Funds Opportunistically: Getting to Undervalued Stocks
Investors can use exchange-traded funds as a way to gain exposure to undervalued areas of the stock market.
Things To Know
- An ETF is likely to get Morningstar’s analysts’ attention if it is trading substantially below their fair value estimate.
How Morningstar estimates values
Equity analysts at Morningstar have placed fair value estimates on 2,000-plus stocks, and by aggregating those fair value estimates, they can also estimate the fair values of hundreds of equity ETFs. To determine whether an ETF is over- or undervalued, they compare their fair value estimate for the fund with its current market price.
An ETF is likely to get Morningstar analysts’ attention if it is trading substantially below their fair value estimate. By contrast, if it’s trading at a premium to the fair value estimate, they will probably take a pass.
Don’t forget the margin of error
End of story? Not quite. Morningstar’s analysts base their forecasts on assumptions that they make about the growth, profitability, and competitive positioning of the firms they’re analyzing. Because all of these assumptions are uncertain to varying degrees, the company wants to afford itself a margin of error when it invests. In that way, if the fair value estimates prove too rosy, they’re not necessarily left in the lurch.
In calculating a margin of safety, it is important to consider all the possible variables including secular trends, macroeconomic themes, and even sector momentum. In Morningstar’s ETF analyst reports, you’re likely to hear it harp on a few recurring themes—company quality (i.e., "economic moat"), business risk, portfolio diversification, and cost. All of these factors impact the fair value estimate that the company places on an ETF and the margin of safety it demands when investing in it.
