Ah, fall is in the air again. That means it's time for my family and me to pile into our Jeep, drive out to the Virginia countryside, and pick apples.
One thing that always puzzled me about apple farms, however, is they always have pre-packaged bags of apples available for sale. Half the fun of battling D.C. traffic and heading out to the countryside is to spend time in the fresh air, hand-selecting the best apples in the orchard. What's more, it's cheaper to pick your own apples.
Call me crazy, but driving a hundred miles to pick up a bag of overpriced apples of uncertain quality seems a tad lazy to me.
When you think about it, buying the pre-packaged apples instead of picking your own is a lot like buying ETFs instead of buying individual stocks. Rather than taking the time to seek the very best stocks in the market, it's much easier -- and costlier, in many cases -- to buy a pre-packaged bag of stocks that fit a certain theme and call yourself diversified.
Yes, now you see why my wife dreads taking me anywhere; I tend to draw investing parallels to everything I see.
Admittedly, I've owned and recommended ETFs in the past, but their purpose has been to fill in diversification cracks in a portfolio rather than to serve as the foundation of the portfolio. So ETFs do have their place, but investors have become so ETF-crazy that their lazy money may have created the perfect scenario for stock-pickers to snatch up the best stocks in the market.
A few rotten apples
The emergence of the ETF in the stock market has been incredible. In October, for example, U.S.-listed ETF assets hit an all time high of $925 billion, more than tripling from a level of $296 billion in December 2005.
And as my Foolish colleague Morgan Housel reported in August stock market ETF assets increased by more than $250 billion while they withdrew $9 billion out of equity mutual funds from February 2009 to June 2010.
Curious, no? It seems that investors may not necessarily be bearish on stocks, per se, but bearish on stock picking. Instead of letting a mutual fund manager use his or her skills to find the best stocks in the market, investors appear to prefer their investments to be indexed in an ETF.
This behavior is having repercussions in the market. Barclays Capital, for instance, noted that this massive inflow of lazy money into indexed ETFs has led to a higher correlation of both good and bad assets, saying that "Since 2005, equity correlation has had a close relationship with the increased ETF volumes relative to the volumes in underlying stocks."
Put another way, the increasing prominence of ETFs may have led to a mispricing of assets and left good stocks cheap and bad stocks expensive. This, in short, is a stock-picker's paradise.
Rising tide
When PotashCorp rejected BHP Billiton's unsolicited takeover bid on August 17, Potash shares jumped 28% as investors cheered management's claims that BHP's offer grossly undervalued the company. This excitement led agriculture-themed Market Vectors Agribusiness (MOO) to gain 5% while the ETF's volume nearly tripled, even though Potash made up only 8% of the portfolio holdings.
On the same day, look at what happened to the other top holdings in the ETF such as Monsanto, Deere, and Syngenta AG:
|
Company |
Weight in ETF as of Aug. 16 |
Price Change |
Daily Volume Change |
|---|---|---|---|
| Monsanto |
8.2% |
2.5% |
85% |
| Deere |
8.2% |
2.5% |
67% |
| Syngenta AG |
7.1% |
3.1% |
73% |
Data provided by Yahoo! Finance.
It's true that good news for one company in a sector can lift the rest of the sector, but this is a bit extreme given that Monsanto, Deere, and Syngenta have no meaningful direct exposure to fertilizer. Monsanto and Syngenta both primarily deal in production-enhancing chemicals like herbicides, pesticides, and seed care while Deere manufactures farming equipment. Indeed, there was no other remarkable news on August 17 for any of these companies that would have explained the jump in share price and trading volume.
Bringing my apple analogy full-circle now, shares of Apple currently make up 20.3% of the PowerShares QQQ ETF -- the second-most heavily traded ETF behind SPDR S&P 500 -- while other strong companies like Oracle
To illustrate how this setup can also skew the valuations of other QQQ holdings, as of November 1st, the ETF had $23.1 billion in assets under management. If you do the math that means the ETF's assets are likely distributed among the aforementioned stocks as such:
|
Company |
Current Index Weight |
QQQ Assets Under Management* |
PEG Ratio |
|---|---|---|---|
| Apple |
20.3% |
$4.7 billion |
0.84 |
|
4.7% |
$1.1 billion |
1.30 |
|
| Oracle |
3.03% |
$700 million |
0.99 |
| Cisco Systems |
2.50% |
$577 million |
1.13 |
| Gilead Sciences |
1.60% |
$370 million |
0.83 |
| Starbucks |
1.56% |
$360 million |
1.29 |
Approximate, based on current ETF weights; Data provided by Yahoo! Finance and Invesco PowerShares.
For those of you who aren't familiar with the PEG ratio, it simply takes the company's price-to-earnings ratio and divides it by the estimated earnings growth rate. The lower the PEG ratio, the more undervalued the stock.
This is indeed a back-of-the envelope valuation method, but it shows clearly that while Apple may be a reasonable destination for capital, it may not be worth four times more capital than Google, six times more than Oracle, eight times more than Costco, and 12 times more than Gilead Sciences and Starbucks.
What to do
The ETF madness has brought more lazy money into the stock market, which has led to a mis-pricing of assets and left some great companies undervalued. Put simply, that means today is a great time to be a stock picker if you know how to identify those mis-pricings.
If you'd like some help building a portfolio of hand-selected companies rather than follow the herd into ETFs, enter your email in the box below to get "Motley Fool Top Picks & Perspectives 2011," a new free report with stock recommendations and portfolio guidance for the year ahead. We'll also tell you more about Million Dollar Portfolio, our real-money portfolio service that buys the best of our investing ideas, opening for the last time this year. To get started, just enter your email in the box below.
