Wealth Manager

We first wrote about AltaVista in the March 2005 issue of Wealth
Manager, and we return this month with a follow-up interview to
discuss his recently launched ranking system. The AltaVista Long-
Term Annual Return Forecast, or ALTAR, condenses fundamental
analysis of ETFs into a single metric.

ALTAR offers a forecasted internal rate of return on ETFs for the long haul by comparing return on equity to price-to-book value and then subtracting fees. Krause emphasizes that ALTAR doesn’t predict ETF performance. Rather, it’s a tool for comparing funds based on their fundamentals and identifying value (or the lack thereof).

Skeptics may wonder if fundamental analysis is worth the effort for ETFs,
which are index funds that trade on exchanges like other listed equities. Krause, of course, argues in the affirmative. In the following interview, he makes a case for reasons
why his brand of ETF analysis is distinct from the competition, and why that matters in this corner of the securities market.

Q: Why does the world need fundamental analysis of exchange-traded
funds?

The traditional approach to mutual fund analysis asks the
wrong questions. Yes, it’s appropriate to look at past performance
and fees for active mutual funds because you’re hiring
a manager, and so it’s entirely appropriate to ask how well the
manager’s delivered in the past and how much he or she costs
in terms of fees. But there’s no active management with ETFs.
There’s nothing inherently good or bad about a sector, investing
style or market cap. What makes it a good investment or
not has nothing to do with past performance; it’s really about
the fundamentals.

If you were considering buying shares of General Electric or IBM,
you’d want to look at more than a price chart; you’d want to know
the earnings growth and so on. I don’t see any reason why you’d go
from fundamentally analyzing one or two stocks to ignoring such
questions for a basket of stocks in an ETF.

Q: Tell us about your rating system for ETFs—the so-called ALTAR, or
AltaVista Long Term Annual Return forecast.

It gives a one-number rating to help narrow the choices for the
ever proliferating list of ETFs. The idea is to take a sort of Warren
Buffett-ownership approach and ask, “What kind of returns could
I expect on my money from this ETF?” But ALTAR is not a market performance call or a price-target prediction. At the end of the day, the return on any investment is
determined by what the market’s willing to offer when you sell.

There are lots of people out there talking about what they think the market’s going to do, and which asset classes have or haven’t performed well in certain circumstances, and what asset classes will do in the future. I don’t want to add my voice to that barrage. I’m trying to provide people with information that they can use to sift through the ETF universe in the hope that, in the very long term, the market recognizes the internal fundamentals. In fact, the
market always, over time, finds value.

Q: How does ALTAR work?

It’s based on the relationship of price-to-book value (P/BV) and
return on equity (ROE), which is a derivation of the old dividenddiscount
model that calculates the present value of future dividends.

Dividends, in turn, are a function of the growth rate of
earnings and the return on equity. It turns out that P/BV is highly correlated to ROE,
but has almost no correlation to the earnings growth rate. As a result, the
two factors that are highly correlated are ROE and P/BV. ALTAR
focuses on those items and is calculated:

ALTAR = (Avg ROE / P/BV) - fees

I use a five-year ROE up to and including the current forecast
year to compare different firms and industries that are at different
stages in the business cycle. P/BV is the multiple on current
year estimates, and fees represent the expense ratio of the fund
in basis points.

Q: What does the ALTAR formula tell us?

A: It forecasts the internal rate of return for shareholders over the
long term—in other words, the returns you can expect if you had
enough money to buy all the businesses [in the index] and operate
them for your own benefit.

Suppose there’s a business that earned an average ROE of 10
percent a year. Assume that the shares are selling at two-times
book—i.e., the “owner’s equity.” If you buy into that stream of
earnings, you can expect a 5 percent return because you’re paying
two-times book value.

In general, the higher ROE, the higher P/BV multiple that you
should be willing to pay. Meanwhile, the lower the ROE, the lower
the P/BV you should pay. That relationship holds up pretty well.

Q: How so?

A: The relationship has one of the strongest correlations between
any two variables that we know of in finance—with rsquared
values regularly in the 60 percent-plus range—whether
for individual stocks or funds such as ETFs compared with other
ETFs. Some funds or stocks will trade above or below where they
should be, or where you would expect them to trade. ALTAR
tries to spot the deviations.

Q: How should investors use ALTAR?

A: As a guide for identifying long-term value. But it’s not a back-tested
model for mindlessly buying a bunch of funds with a high ALTAR
score. You wouldn’t want to do that, just as you wouldn’t want to
buy mutual funds solely based on the Morningstar rating.
For example, just because small-cap stocks in general rank
poorly in ALTAR at the moment doesn’t mean that you should
abandon the category altogether. You may, however, want to
lighten up on small caps. In addition, within the small-cap category,
you might favor the iShares S&P Small Cap 600 with an
ALTAR score of 5.6 percent over the iShares Russell 2000, with an
ALTAR score of just 3.3 percent.

Q: You make an adjustment in ALTAR for fees. but you’ve written that
fees aren’t all that important for ETFs.

A: It’s the first part of the ALTAR score—ROE and P/BV—that’s going
to make or break an investment. It’s not fees, which are the second
term in the ALTAR equation. Too much emphasis is placed on
fees by some who are yacking incessantly about saving five basis
points here or there while no real analysis is offered as to whether
a fund is a good investment in the first place.

For example, in 2000, comparing fees among technology funds
didn’t really matter. Tech was a terrible investment. All else being
equal, fees matter. But when is all else equal?

Yes, focusing on mutual fund fees is valid, because some are
very expensive and don’t justify the fees based on the performance
delivered. But with an ETF, the fees are low and people are haggling
over little differences and ignoring the main part, ROE and P/BV.

Q: Some strategists argue that ETFs don’t require much, if any, fundamental
analysis, and that investors are better off focusing on
asset allocation.

A: I certainly wouldn’t throw ETFs willy-nilly into a portfolio without
an asset allocation plan. Asset allocation just brings you to
general asset classes; you still have to pick ETFs, and that shouldn’t
be done willy-nilly because there are differences.

But when you run your asset allocation model, presumably you
have certain amounts earmarked for each category, such as large
cap, small cap, etc. There are quite a few ETFs you could choose
to represent each of those asset classes, and some funds are very,
very different.

Consider a small-cap equity allocation. You could pick the iShares
Russell 2000 or the iShares S&P Small Cap 600. Each has radically different
price-to-earnings ratios. The Russell is much more expensive.
Also, history suggests that if we go into a recession, things can get
much worse for the Russell 2000 compared to the S&P 600.

Q: Why?

A: The S&P 600 holds the largest of the small-cap stocks, while
the Russell 2000 has more smaller small caps if you will, down to
what’s really microcap territory. As a result, a larger share of Russell
2000 companies tends to be more vulnerable in a recession
compared to the S&P 600. That was the case in the last recession,
when the companies in Russell 2000 in aggregate lost money. By
contrast, profits only declined for the S&P 600.

The iShares S&P Small 600’s forward-looking 2007 P/E is 17, and
iShares Russell 2000’s is 21.3. Also, companies in iShares S&P 600,
on average over five years, had an average ROE of 12.5 percent. That
compares with an average ROE of 8.1 percent for the Russell 2000.
The S&P 600 was recently trading at 2.1-times book value; Russell
2000 was trading at 2.3-times book value. The bottom line: The Russell
2000 has a slightly higher book-value multiple on roughly 60
percent of the profitability compared to the S&P 600.

Overall, the S&P 600 rates much better in the ALTAR score versus
Russell 2000. The ALTAR score on iShares S&P 600 was recently 5.6
percent, while iShares Russell 200 was only 3.3 percent.

Maybe some of the decision about picking an ETF depends on
the client. Perhaps you have an aggressive client who thinks the
economy’s going to do great and so he wants to take more risk,
in which case iShares Russell 2000 might be the answer. But if another
client is more conservative and wants to be more defensive,
then iShares S&P 600 could be the answer. But you couldn’t make
the distinction without doing the fundamental analysis.

Q: What other analysis do you run on ETFs?

A: The valuation metrics that most people look at, including priceto-
earnings ratio, price-to-cash flow, price-to-sales, yield, earnings
growth, sales growth, profit margins. I also track the trend in recent
earnings estimates so that you can see whether estimates are
being cut or raised.

Q: Speaking of fundamental ETF analysis, what’s your take on the
fundamentally weighted ETFs?

A: I am quite a fan of fundamental indexing. We’re getting new flavors
and gimmicks in indexing all the time, but I think fundamental
indexing is one of the most genuine and promising developments
in a long time. In a market-cap weighted index, you’re overweight
the overvalued stocks and underweight the undervalued stocks.

Q: Some critics say that fundamental weighting is really just active
management wrapped in an index fund.

A: I disagree. It’s not active management because there’s nothing
subjective to it. I could recreate a fundamental-weighted index because
the index is based on publicly available information. It’s not
based on some analyst’s estimate of companies’ fundamentals.
It’s another quantitative way to put together an index.

Q: How does the PowerShares FTSE RAFI 1000, a large-cap fundamentally
weighted ETF, compare on ALTAR?

A: Actually, it looks about average. This is a case where the
ALTAR score isn’t the be-all and end-all. The way I think about
a fundamentally-weighted ETF like the PowerShares FTSE RAFI
1000 is that it’s really perfect for what I call the “set-it-and-forget-
it” investor who doesn’t want to rebalance, but wants to
outperform the market over time by avoiding market excesses.
And that’s what this ETF will do. But with a fund that includes
1,000 stocks spread across so many market caps, you’re bound
to have an average ALTAR score.