ETF Expert

Morningstar used to be a one-trick pony. The company rated mutual funds… and they weren’t particularly good at it.

For instance, in 1999, nearly every investment in the Janus stable held 4 or 5 stars. The primary reason? Janus products demonstrated superior performance on a relative basis in most stock categories over popular time frames (e.g., 1 year, 3 year, etc.).

Did Morningstar adjust for sector risk? Did they analyze individual holdings of funds? Did they re-rate funds when a manager departed? Not really. In fact, when tech-heavy Janus vehicles crashed with the NASDAQ in the 2000-2002 bear, 4-star and 5-star ratings didn’t adjust until after the dot-com disaster. In other words, Janus mutual funds didn’t receive 1-star and 2-star ratings until it was too late for investors.

Yet, to be fair, Morningstar has come a long way in a very brief time. The company improved upon their mutual fund rating system in the 2000s, hired qualified financial analysts to research and rate individual stocks, as well as add ETFs to their assessments. Today, Morningstar can offer fair value estimates on scores of ETFs based upon proprietary valuations of the underlying stock holdings in the ETFs. That’s far more sophisticated than the old Morningstar method of using relative performance data alone.

Form time to time, I check in with the ratings giant. Premium Members are privy to ”ETF QuickRank,” where an investor can sort a variety of ETFs by a valuation rating. Based on an ETF’s current price as well as a proprietary methodology for determining fair value, Morningstar may designate an investment as “overvalued,” “fairly valued” or “undervalued.”

Undervalued designations will have some of the lowest “P/FV” ratios in the database. And for the purpose of this exercise, I wanted to take a look at 3 of the lower P/FVs around:

1. Market Vectors Steel (SLX). Morningstar currently shows an overall, 1-star rating for SLX. It seems a bit ironic to give the lowest possible rating to an ETF with one stroke of the keyboard, then serve up a quick-rank “undervalued” valuation rating with a P/FV of .72. In fact, you won’t find a less expensive price tag than this steel-producer investment in the entire Morningstar quick-rank listing.

There may be a critical reason for why the most undervalued bargain on the board receives the lowest overall rating (1 star) possible. I imagine it is primarily a function of the dramatic underperformance of steel producers in 2011, particularly international steel producers; iron ore prices have been erratic and global demand plummeted. That said, if China is indeed on its way back from the “forgotten,” resources-related investments may bounce back in a big way in 2012. 

2. iShares DJ Oil & Gas Exploration (IEO). Exploration and production of oil and natural gas may be a risky endeavor, but the potential reward for selecting IEO may be worthy of the investment risk. Not only do the folks at Morningstar give IEO an overall rating of 4 stars, but the current price is roughly 20% below the fair value estimate (P/FV =.81).

On the other hand, IEO is highly dependent on the price of oil and natural gas — commodity prices that are prone to extreme fluctuations. Natural gas is so cheap in the U.S., in fact, that many of these corporations are hoping to export their discoveries abroad. The political risk involved with exporting fossil fuel makes it even more difficult to identify IEO’s prospects.

Here, then, it might be best to incorporate favorable fundamental ratings with some technical analysis. Below, we can see that IEO is above its 50-day and 200-day moving average. That said, IEO made a similar move in November that didn’t hold up.

3. iShares DJ Telecom (IYZ). At first glance, I was a bit surprised to see telecom on the undervalued list. After all, Verizon and AT&T constitute 1/3 of the investment returns. And with the stocks of both companies performing so well recently, I would have expected IYZ to receive a less attractive ”fairly valued” rating.

On the other hand, telecom giants are increasing part of the TV/Internet picture. (They’re not just for phone lines anymore.) Moreover, businesses are using networks to move data from point A to point B. And the ever-increasing world of mobile services accounts for a substantial portion of telecom revenue. Plus, IYZ would need to climb 16.5%… just to get back to previous 52-week highs.

You can listen to the ETF Expert Radio Show “LIVE”, via podcast or on your iPod. You can follow me on Twitter @ETFexpert.

Disclosure Statement: ETF Expert is a web log (”blog”) that makes the world of ETFseasier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships. You may review additional ETF Expert disclosure details here.