In an effort to brush up on my fundamental stock analysis skills, I recently read “Fire Your Stock Analyst! (Analyzing Stocks On Your Own),” by Harry Domash. Along with lots of useful definitions and examples, the book provides a long and exhaustive scorecard for figuring out if a stock is a growth or value opportunity. That scorecard has 11 sections, each containing multiple financial metrics -- good for analysis, but not something most investors want to slog through.
And so the book does (unwittingly) make a case for investing in fundamentally weighted stock ETFs, which filter and weight stocks on measures like revenue, earnings, cash flow, a mix of those and more. These ETFs have brought in $48 billion in new cash since the start of 2013. They're often called “smart beta” ETFs -- with beta describing a broad market return like that of the S&P 500 Index -- and marketed as a way to beat the market.
That pitch has sparked controversy in the ETF industry. The reality is that these products won’t always beat their traditional peers, which simply weight the stocks in their portfolios by their market capitalization (ye olde calculation of shares outstanding multiplied by stock price).
Still, fundamentally weighted stock ETFs, acting as stock-analyst robots, do remove emotion from a buy or sell decision, and do it cheaply. There are now 65 of these funds. While there will continue to be examples of such funds underperforming traditional peers, the two funds below are good examples of fundamentals-driven ETFs that have beaten the market consistently.
PowerShares FTSE RAFI US 1000 Portfolio (PRF)
One of the oldest and largest of the bunch is PRF, with $3 billion in assets. It scores each of the 1,000 stocks in the FTSE RAFI US 1000 Index on a combination of five-year trailing book value, cash flow, sales and dividends. It then weights the stocks by their score and rebalances its portfolio annually.
PRF's holdings are all in the U.S., and 91 percent are large-cap stocks. Since its start in 2005, PRF is up 86 percent, versus a 68 percent gain for the S&P 500, mainly because when investors raced out of financial stocks in 2009, those same stocks became good values, according to PRF's screens. The ETF went from having 16.7 percent of its assets in financials to 25.9 percent, a move that paid off over time. PRF charges .39 percent of assets on an annual basis, roughly a third of the cost of an active mutual fund.
RevenueShares Large Cap Fund (RWL)
This ETF's approach is one of the simplest of the smart-beta set: Weight all S&P 500 stocks based on their revenue. According to the company, studies show that industry sectors with lower price-to-sales ratios tend to perform better. The lower the ratio, the less you are paying for the revenue the company generates.
The way the ETF rebalances every quarter shifts it into stocks with lower price-to-sales ratios. If a stock's price -- but not its revenue -- went up over the quarter, the ETF buys fewer shares of the stock. If the stock's price went down, but revenues stayed the same or increased, it buys more shares of the stock. The securities in the ETF remain the same, but their weighting in the ETF will likely differ from quarter to quarter.
RWL is one of a line of eight ETFs focused on revenues. In 2013, it returned 38 percent to the S&P 500's 32 percent. The edge came from its larger stakes in revenue-producing consumer-staples stocks like CVS Caremark Corp. (CVS) and The Kroger Co. (KR), which performed better than the market.
Since its 2009 start RWL is up 166 percent, to the S&P 500's 147 percent gain. It charges .49 percent and has $210 million in assets. It trades 57,000 shares a day. In ETFs with limited liquidity like this, it's a good idea to use a limit order, which lets you set a specific price at which you'll buy or sell.
For investors who like the idea of using fundamentals to identify winners, there are many more of these ETFs out there to explore. The stock-analyst robots are multiplying.