What are we looking for?
Canadian-listed ETFs that appear undervalued based on Morningstar’s fair value analysis
The screen
Last week, Tom Bradley wrote a great article reminding investors about the timeless importance of valuations when investing. In the stock world, there are many ways to value a company, of which Mr. Bradley highlights the use of ratios such as price-to-earnings, which is particularly useful if compared across companies. As a complement, Morningstar favours a bottom-up fundamental approach, which involves predicting the expected cash flows a company will produce a few years into the future and then discounting those cash flows back to today to arrive at a present “fair” value. This discounted cash flow approach is widely used by sell-side research analysts, but experienced investors know that it is far from an objective exercise.
Unique to Morningstar’s equity analyst team is the consistent assessment of “economic moats,” or competitive barriers to entry. There are fives unique sources of economic moats: (1) Switching costs, which are those obstacles that keep customers from changing from one product to another; (2) The network effect, which occurs when the value of a good or service increases for both new and existing users as more people use that good or service; (3) Intangible assets, such as patents, government licences and brand identity that keep competitors at bay; (4) A company with a cost advantage can produce goods or services at a lower cost, allowing them to undercut their competitors or achieve higher profitability; (5) Efficient scale benefits companies operating in a market that only supports one or a few competitors, limiting rivalry. In financial terms, these companies are expected to produce a return on invested capital in excess of their cost of capital (an increasingly relevant measure given that the cost of capital has increased alongside recent interest-rate hikes).
When we aggregate the fair value estimates for individual stocks in the portfolio (taking into consideration their weighting), we are able to see whether a portfolio or fund is trading below its fair value. With this idea in mind, this week I ran a screen across all Canadian-listed stock ETFs that appear undervalued. I screened the universe of roughly 1,400 Canadian-listed ETFs for those that:
- Received a four- or five-star Morningstar Rating for Funds (also known as the “star” rating), indicating that the fund has historically outperformed respective category peers after fees, on risk-adjusted basis.
- Received Morningstar Medalist Rating of gold, silver or bronze, highlighting 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 the list of resulting ETFs by the difference between recent close price and Morningstar’s fair value estimate, with the most undervalued ETFs appearing first.
What we found
The top 20 ETFs that qualified in the screen are listed in the table accompanying this article, alongside categories, MERs, trailing performance, inception dates and ratings. Investors are urged to first look at the category to which each fund belongs, given that the rating is meant to measure performance against category peers.
This article does not constitute financial advice, it is always recommended to conduct one’s own independent research before buying or selling any of the funds or ETFs mentioned in this article.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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Ian Tam, CFA