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Wednesday, 9 April 2008

With Blood on Wall Street, Is It Time to Buy?

By Jeffrey Ptak, CFA, CPA

As many of you know, we recently made some exciting changes to our ETF research. We've written at length about our approach to ETF research, what makes it different, and how investors can benefit from it. But sometimes a picture--or, in this case, a sample Analyst Report--is worth a thousand words.

- Wall Street--that is, the nameplate banks, brokerage houses, exchanges, and specialists that comprise the financial world's nerve center--has gotten rocked recently. Bear Stearns (NYSE:BSC - News) imploded amid vanishing confidence in its ability to make markets. The big brokerages like Merrill Lynch & Company (NYSE:MER - News) and Morgan Stanley (NYSE:MSNews) have been laid low by massive write-offs. Lehman Brothers (NYSE:LEH - News) recently had to raise $4 billion in capital in order to allay fears that it was the next domino to fall. And that's to say nothing of E*Trade Financial Corporation (NasdaqGS:ETFC - News), which nearly collapsed, or the other capital markets-dependent businesses ( Chicago Mercantile Exchange (NYSE:CME - News) and NYSE Euronext (NYSE:NYX - News)) that have gotten caught in the downdraft. There's blood, as they say, on the Street.

The recent performance of iShares Dow Jones US Broker-Dealers (NYSEArca:IAI - News)--which invests in many of these names--well attests to this. The fund suffered a 27% loss in the first quarter alone and is down nearly 25% for the trailing year through April 4, 2008.

Yet, if fear, to borrow the hoary saying, is the surest sign of a buying opportunity, does that make these stocks a screaming "buy" at these levels? Granted, we consider our fair value estimates on a number of these firms to be very uncertain, not least because of the opaque nature of the businesses and their financial reporting. We're also keenly aware that other disasters could loom on the horizon. But would a fund like iShares Dow Jones U.S. Broker-Dealer diffuse those risks to the point that the group is a bargain as a whole?

My colleague, Emiko Kurotsu, recently took a whack at answering that question in her analysis of the iShares fund. That report is below.

iShares Dow Jones US Broker-Dealers
by Emiko Kurotsu

Rating/Data 04-04-08

Valuation Rating -- Fairly Valued ETF Market Price -- $40.25 ETF Fair Value Estimate -- $47.82 ETF Expected Return -- 18.4% annualized (three-year time horizon)

Analyst Note 04-03-08
IShares Dow Jones US Broker-Dealers is risky. The fund invests in the shares of capital markets firms that make markets in securities, trade for their own account, or put together deals like mergers and securities offerings. Prominent examples include nameplate investment banks, retail brokerages, and exchanges like NYSE Euronext. Confidence is the lifeblood of these businesses. When it wanes, these businesses can fail. Further, given the level of interconnectedness in the capital markets, no firm is an island. Thus, the failure of one firm can ripple throughout the financial system, meaning that investors here court not just firm-specific risk, but also a degree of systemic risk.

Given the preceding, we'd invest here only at a healthy margin of safety: The fund would have to trade at least 20% below our fair value estimate before we'd recommend it. Although the investment banks and brokerage houses have gotten battered recently in the wake of Bear Stearns' implosion and continued fallout from the subprime-lending crisis, they're still not quite cheap enough for our liking. This portfolio was trading at a 15% discount to our fair value estimate as of April 2, 2008.

That said, it's worth noting that our fair value estimates on a number of the fund's exchange, brokerage, and specialist holdings remained under review as of this writing. Because we assume that under-review stocks are trading at fair value, these stocks--which recently soaked up around 28% of the fund's assets--depress the portfolio's fair value estimate (assuming they're trading at discounts to our fair value estimate, that is).

If we limited our scope solely to stocks that are carrying active fair value estimates, those names were trading at a roughly 23% discount to what we think they're worth in the aggregate as of April 2. The fund's top four holdings--Morgan Stanley, Goldman Sachs (NYSE:GS - News), Merrill Lynch, and Lehman Brothers--were trading at 23%, 20%, 30%, and 39% discounts to their respective fair value estimates as of that date, as investors have adopted a sell-first-ask-questions-later mentality in discounting the shares amid continued turbulence and fear in the capital markets.

Thesis 04-03-08
IShares Dow Jones US Broker-Dealers invests in the shares of firms that make markets in securities and trade for their own account. The index weights its 30 or so holdings by market cap, so giants like Morgan Stanley hold sway atop the portfolio.

The "broker-dealer" rubric covers a wide variety of firms. Indeed, the fund includes everything from nameplate investment banks with big trading operations (Goldman Sachs) to retail and online brokers ( Charles Schwab (NasdaqGS:SCHW - News) and E*Trade), exchanges (NYSE Euronext), and market specialists ( LaBranche & Co. (NYSE:LAB - News)).

Not surprisingly, the portfolio's quality varies widely. For instance, while the top of the portfolio boasts blue chips with sterling reputations (Goldman Sachs) and wide-moat exchanges that benefit from strong network effects (Chicago Mercantile Exchange), the fund invests in a number of other firms with flimsier advantages. For instance, TD Ameritrade (NasdaqGS:AMTD - News) competes in the intensely price-competitive retail brokerage business, where it's vulnerable to encroachments by better-diversified players who offer trading at fire-sale rates to induce sales of other, more lucrative services. All told, 10 of the 24 portfolio holdings we cover lack economic moats altogether.

That said, many of the fund's holdings fall somewhere in between these two poles, including some of the bulge-bracket investment banks it owns. Merrill Lynch, for instance, has trenched out a narrow moat by dint of its massive wealth management and distribution apparatus. In addition, the firm also boasts a premier investment banking franchise. That has translated to attractive returns on capital over the long haul.

While that burnishes the portfolio's quality, we'd still need a wide margin of safety to invest here. As Bear Stearns' implosion vividly illustrated, market confidence is the lifeblood of capital markets businesses. Thus, when confidence is shaken, these firms can fail with startling velocity. Given the market's continued skittishness, that explains why our analysts consider their fair value estimates on a number of these names to be extremely uncertain. That caution extends to this ETF as well, which we wouldn't recommend unless it was trading at least 20% below our fair value estimate.

Even then, we'd hesitate to make this our first choice, as KBW Capital Markets (AMEX:KCE - News)--which invests in a very similar group of firms, albeit with a bigger slug of high-quality asset-management stocks thrown in--is cheaper to own than this fund.

Portfolio Construction
This ETF tracks the Dow Jones U.S. Select Investment Services Index, which encompasses a range of specialized financial-services firms, including securities brokers and dealers, online brokers and dealers, and commodity and stock exchanges. The fund also includes investment banks that have significant brokerage and trading units, like Goldman Sachs, Merrill Lynch, and Morgan Stanley. The index is compact, spanning fewer than 30 holdings, which it weights based on free-float adjusted market cap. While the top 10 holdings account for a hefty 62% of assets, the typical firm here isn't a mega-cap bank: The fund invests about 40% of assets in large caps, with the balance in small caps (30%) and mid-caps (30%).

Fees
This fund's narrow focus on domestic brokers and dealers is somewhat unique. However, it's comparable to KBW Capital Markets, which costs only 0.35% per annum, versus this fund's 0.48% expense ratio.

Although not an explicit cost, each of this fund's holdings courts risk. We can express that risk as a percentage cost of equity. The COE represents the minimum return that an investor would accept for investing in a particular stock. It's also the rate at which our analysts discount a firm's forecasted cash flows in estimating its fair value. Thus, the riskier a firm, the higher its COE and, thus, the lower its fair value.

This portfolio's roughly 11.8% weighted-average COE is the highest among financials ETFs we cover. The high COE is indicative of the capital-markets sensitivity of the holdings here. To arrive at the fund's hurdle rate, we add this COE to its expense ratio.

Bulls Say

This ETF's 0.48% expense ratio is much lower than the typical open-end financial-services fund's. This fund has done a good job of tracking its underlying index. The fund has not distributed any capital gains since its launch in May 2006. This is the only fund of its kind to focus exclusively on domestic brokers and dealers, a strategy that might appeal to those seeking a surgical way to gain access to some of the marquee names in the investment banking and brokerage business.

Bears Say

This fund's narrow mandate and concentrated portfolio has made it a bit more volatile than the typical financial-services ETF. Compared with better-diversified financial-services ETFs, this portfolio's quality is below average. Rival funds like the iShares Dow Jones US Financial Services (NYSEArca:IYG - News) and Vanguard Financials ETF (AMEX:VFH - News) invest almost twice as much in wide-moat names. Investors seeking to build a well-diversified portfolio probably don't need this fund, whose holdings tend to show up in better-diversified financials portfolios.

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