In search of undervalued U.S. equity funds with solid track records

What are we looking for?

Outperforming U.S. equity funds that appear undervalued.

The screen

Across the 63 categories of mutual funds and ETFs here in Canada, the U.S. equity category continues to shine brightly in terms of recent performance. On average, funds and ETFs in this category provided returns of 18 per cent over the past 12 months. This might not be a surprise, given the run-up in large technology names such as Amazon.com Inc. and Microsoft Corp. That said, a cautious investor might take a pause given the sky-high valuations that come along with great performance. With this in mind, today I ran a screen to find Canadian-listed ETFs in the U.S. equity category that have performed well over a longer period and appear undervalued, based on Morningstar’s assessment. I first looked for ETFs that:

• Have received a Morningstar Rating for Funds (informally known as the “star” rating) of four or five stars. This rating is an objective look back at the risk-adjusted, after-fee performance of the fund, relative to its category peers. The rating considers the past 10 years of performance history, if available, and puts emphasis on the past three years. Our data show that although the star ratings are backwards-looking, funds that have received five stars as a group outperform those that have received four stars, three 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, as compared with those that have historically underperformed peers.
• Have received a Morningstar Medalist 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).
• Have an aggregate fair value estimate that is lower than the most recent market close price. This figure is the asset-weighted fair value of the stocks in an ETF portfolio that are under coverage by Morningstar equity analysts, divided by the ETF’s shares outstanding.

The fair value estimate screen is of particular importance given the topic. Morningstar’s analysts derive a stock’s individual fair value estimate using a fairly traditional discounted cash-flow model. However, a large input to this model is the analysts’ assessment of a company’s economic moat, or competitive barriers to entry. There are five unique sources of economic moats: (1) Switching costs are those obstacles that keep customers from changing from one product to another; (2) The network effect 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 are things 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.

Companies with wide moats are those that Morningstar predicts will maintain competitive advantages for more than 20 years, while those with narrow moats are predicted to maintain advantages for 10 years. 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).

What we found

The funds that qualified in the screen are listed in the table accompanying this article, alongside their MERs, historical performance, inception dates and ratings. Also displayed are the percentage of each ETF’s holdings that have wide, narrow and no economic moats.

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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