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What are we looking for?

Entry points into Canada’s oldest ETF, the iShares S&P/TSX 60 Index ETF (XIU-T).

The screen

To say that investing in Canada’s main stock index is a roller coaster is an understatement. Between the effects of the pandemic, fluctuating oil prices and less-than-stellar performance of financials in a rising interest rate environment, it has been a tough go for investors in blue-chip Canadian stocks over the past three years. Still, true value investors understand that patience is a virtue – not only in terms of finding the right entry point into an investment, but also in waiting for the market to realize valuation potential.

For investors with some dry powder, today I illustrate the concept of value investing in an index by utilizing the equity portfolio valuation analysis workflow within Morningstar Direct’s analytics lab. In short, the analysis aggregates Morningstar’s fair value estimates of the stock holdings in a portfolio as a time series and illustrates when the portfolio (or index) is trading above, below or at fair value. Moreover, the analysis also observes the ex-post (i.e., after the fact) performance of the same portfolio one and three years after the fair value assessment to understand the correlation between valuations and future performance.

I note importantly that Morningstar’s fair value estimates stem from our equity analyst team and utilize the concept of economic moats (a term coined by Warren Buffett that speaks to competitive barriers to entry) as a core input into our valuation methodology. 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 years or more. This, in combination with a traditional discounted cash flow model, is what drives Morningstar’s fair value estimate for stocks.

What we found

Value investing in an index

Morningstar Fair Value Analysis, iShares S&P/TSX 60 ETF (XIU-T)# of Month-End ObservationsAverage of 1-year forward return (%)Average of 3-year forward return (%)
Fairly Valued546.8%7.9%

Source: Morningstar Direct Analytics Lab | Data as of Sept 30, 2023

Based on September month-end data, Morningstar’s analysis shows that the price to fair value on the S&P/TSX 60 index is roughly 0.92 times. In other words, if all 60 companies that make up the index reach their respective fair values, investors in the index stand to make an 8-per-cent return. Of course, this begs the question of when. Though there’s no crystal ball to answer that question, the table accompanying this article tests the concept using historical data.

The table shows that, over the past 10 years, buying the S&P/TSX 60 index when it is undervalued tends to produce better ex-post results than buying it when it is overvalued or even fairly valued. For example, over the past 10 years, there were 22 month-ends where the index was overvalued based on Morningstar’s estimates. On average, the one-year return had an investor bought the index during these months was 6 per cent, whereas buying the index during one of the 10 months it was undervalued produced, on average, a one-year return of 7.1 per cent. The results are further magnified when we observe three-year ex-post returns.

This article does not constitute financial advice. It is always recommended to conduct one’s own, independent research before buying or selling the fund mentioned in this article.

Ian Tam, CFA, is the director of investment research for Morningstar Canada.

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