What are we looking for?
Undervalued stock funds, according to Morningstar’s stock analysts
The screen
As headlines continue to point to uncertainty over U.S. president-elect Donald Trump’s view on global trade, markets seem to be chugging along, reaching heights that would have any skeptical investor reeling with doubt. For fundamentally focused value investors, the stellar performance of U.S. stocks makes it extremely difficult to justify entering the market through broad market index ETFs, especially if they are constructed traditionally via market-cap weighting, given the runup of the Magnificent Seven stocks. Today we turn our attention to Canadian-domiciled equity funds that Morningstar’s analysts believe hold companies that are fundamentally undervalued.
Though Morningstar is well known for rating and ranking mutual funds and ETFs, the firm also employs one of the largest independent equity analysts teams in the world, with coverage of roughly 1,500 publicly listed companies. Unique to the analysis is assessment of “economic moats,” or competitive barriers to entry.
There are fives 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.
In financial terms, these companies are expected to produce a return on invested capital in excess of their cost of capital. This assessment of economic moat drives the discount rate used in the model, and subsequently the fair value estimate of a stock’s price. When combined with portfolio holdings information, we can get a glimpse into whether a portfolio of companies held by an ETF or fund is over- or undervalued, noting that Morningstar must cover at least half the stocks in the portfolio to publish a fair value.
Keeping this concept in mind, today’s screen looks for equity funds that appear undervalued based on this fair value analysis of the portfolio as a whole. Only Canadian-listed ETFs were considered in this screen.
What we found
The funds that met the above requirements are listed in the table accompanying this article, inclusive of their MERs, Morningstar Rating for Funds (a comparison of after-fee risk-adjusted returns relative to the category), inception dates, trailing performance and discount-to-fair-value (where a figure like 17 per cent implies that the fund’s holdings are on aggregate 17 per cent undervalued based on Morningstar’s estimates).
The table is sorted first by category, then ranked by discount-to-fair-value. Readers will quickly notice that many of these funds are not rated, this is either because of the limited track record, or the funds’ classification in a non-homogenous category (like sector equity, for example).
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 mentioned in this article.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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