What are we looking for?
Canadian-domiciled ETFs with upside potential based on valuations.
The screen
For value investors, market corrections and short-term volatility can provide opportunities to own a piece of a company at a discount. As a value investor, the hope is that the market has mispriced the fair value of a company, giving the patient investor a chance to reap the benefits over a longer term. Of course, this is dependent on the investor’s ability to accurately gauge the company’s fair value in the first place. Morningstar uses the concept of economic moats (a Warren Buffett-coined term that speaks to competitive barriers to entry) as a core input into how we value a company. The belief is that companies with wide moats will be able to produce return on capital in excess of their cost of capital for 20-plus years. This, in combination with the traditional discounted cash flow model, is what fuels Morningstar’s fair value estimate for stocks.
Today, I use Morningstar Direct to screen for Canadian-domiciled ETFs that on aggregate have upside potential based on a roll-up of our individual company fair value estimates. In other words, if all the companies in the portfolio reached their fair value, what would the portfolio be worth? To do this, I started by looking for ETFs that were well-rated by screening on two counts:
- a 4- or 5-star Morningstar Rating for Funds, indicating that the fund has historically outperformed respective category peers after fees on a risk-adjusted basis. Our data shows that although the star ratings are backwards-looking, funds that have received 5 stars as a group outperform those that have received 4 stars, 3 stars, etc. in periods after receiving the rating. In other words, it’s more likely that a fund manager with a track record of outperforming peers will continue to outperform in the future.
- a Morningstar Quantitative Rating of gold, silver or bronze, isolating funds that Morningstar believes will produce excess after-fee returns in the future, based on our analysis of people (quality of the management team), parent (stewardship of the fund company) and process (robustness of investment decision-making).
I then ranked this list based on the difference between our fair value estimate roll-up (as described above) and the recent NAV of the ETF.
What we found
The 18 ETFs that met the above requirements are listed in the accompanying table, alongside their fees, tickers, categories, trailing performance, ratings, inception dates and fair value estimates. It is worthwhile noting that a number of these ETFs (ZGQ, ZUQ, IZD.B, FCUZ, VGG, DGR.B) are smart-beta products, which systematically grant consistent exposure to investment factors such as value, growth, dividends, etc., for better or for worse.
This article does not constitute financial advice. Investors are encouraged to conduct their own research before purchasing any of the investments listed here.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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