This year, global stock markets have been in dire straits. Well, some more than others.
The 2010s have sometimes been referred to as a “Value Winter” or a “Value Drought”, opinions vary. Then the tables turned. So far, 2022 has been more of a “growth drought,” much to the chagrin of tech investors. This was the high-tech multiple (broadly defined) and especially the speculative tech cohort that bore the brunt as investors hastily stripped growth premiums from stock valuations, relentlessly and sometimes hysterically sold, preparing for an era of higher rates for longer and scarcer capital, and therefore lower growth.
In my article on the First Trust Dow Jones Internet Index ETF (NYSEARCA:FDN) published on December 31, 2021, I warned my dear readers that buying long tech names, whether or not they belong to the flagship mid-cap league, was a disastrous decision at this point. And I was right. It was quite simple to predict this result. Technological carnage was in the cards as two factors came together. They were too expensive (as I illustrated using Quant data) and interest rate hikes by the Fed seemed quite certain, although the magnitude was not yet known and the inflation was not that rampant, so there was hope that smaller increases would be enough to quell it, and the impact of the tightening would be limited for both Main Street and Wall Street.
If investors were asking which investment vehicle has lost nearly all of its pandemic premium (tailwinds from ultra-loose monetary policy, record liquidity, stay-at-home economics, etc.), FDN is an example that immediately comes to mind.
The ETF has seen its price crash this year almost incessantly, now trading around the April 2020 level. At one point in June, it was apparently ready to test the March 2020 low.
For some time, investors have been pointing out that the trends that accelerated during the pandemic are secular, but that hasn’t saved growth portfolios from multiple contraction. And FDN peers targeting similar or adjacent themes have certainly not escaped unscathed. Specifically, this year has been a real calamity for the ARK Innovation ETF (ARKK).
It’s a perfect synthesis of a phenomenon where age-old trends believed to completely reshape the modern economy over the decades (AI and robotics, fintech, the sprawling universe of electric vehicles, etc.) meet the harsh new reality of monetary policy. round. Rating matters.
Below is the comparison of total returns for a few growth and innovation focused ETFs I cover, namely the SPDR FactSet Innovative Technology ETF (XITK), Invesco DWA Technology Momentum ETF (PTF) and Global Internet (OGIG ). ARKK is also added. The table below compares their monthly returns in 2022 through July to those of the iShares Core S&P 500 ETF (IVV).
As can be seen, although the losses have accumulated in the first half of 2022, some positives have emerged recently. July was the month that tech-heavy portfolios saw a rally, although the magnitude of the rebound varied across the board, with FDN registering the third biggest improvement in the selected peer group.
In this regard, the main question at the moment is whether FDN has become a buy after the crisis of the first half and the impressive rally in July. Has the evaluation become more realistic? And what happened with the growth rates? Are there other risks to consider? Let us dig.
Significant changes: valuation becomes more realistic, momentum weakens unsurprisingly
Admittedly, FDN’s portfolio has undergone changes since my previous post, and not just in terms of composition. Factor exposures have also changed, and some even significantly.
To recap, this First Trust ETF invests shamelessly in long-term growth. Its basket of stocks mirrors the Dow Jones Internet Composite Index, the benchmark index drawing its forty components from internet commerce (15 components) and internet services (25 components), the two industries poised to benefit from strong secular trends.
Since December, despite a quarterly rebalancing, the structure of the FDN portfolio has remained almost homogeneous, with minor additions and deletions. For example, Opendoor Technologies (OPEN) managed to qualify for inclusion, now representing 0.6% of net assets, while Wayfair (W) and Vonage Holdings (traded with a symbol VG on Nasdaq) have removed (a combined weight of approximately 2%). VG was acquired by Ericsson (ERIC).
What has changed profoundly is factor exposure, which is succinctly depicted by the graph summarizing the Quant data below. To clarify, “relatively undervalued” is for stocks with a quantitative rating of at least B- and “relatively overvalued” is for those with ratings of D+ and worse; the same logic applies to the remaining data.
The first takeaway is that stock valuations of internet stocks have skyrocketed for years as investors eye unfettered growth, but 2022 has put an end to that. As you can see, the share of overvalued companies has fallen to ~67%, while those with attractive prices have increased.
At the same time, we see a slight decline in exposure to growth leaders, while growth laggards have captured a larger share of net assets. Here again, this is rather a direct effect of the contraction in growth premiums.
Then the quality even improved, albeit marginally, with the most profitable titles now accounting for 87.5%.
As the FDN’s holdings have taken a big hit, the momentum has likely waned. The share of the most dynamic stocks fell by 26%.
And finally, Wall Street dampened its enthusiasm by making realistic adjustments to tech earnings, as the share of stocks with at least B-EPS review ratings is now one-fifth lower.
Another graph allows you to judge the evolution of the portfolio from yet another angle. This is the summary of the growth outlook for the holdings, which is manifested in the forecast EBITDA and revenue growth. V, VG, OPEN, along with a few other stocks that did not have analyst consensus EBITDA estimates in December, were removed; overall, the chart covers 31 stocks or almost 80% of the portfolio. The red dots correspond to the figures for the end of 2021.
As you can see, a lot of optimism has evaporated. Outliers like Zoom Video Communications (ZM), Pinterest (PINS), and Datadog (DDOG) have seen their growth rates decline mercilessly.
To bring in a little more color, here are the same datasets wrapped up in a different graph. A series of downward revisions becomes even sharper.
Take-out? 2022 has been a rude awakening for investors and analysts. Ratings have become more realistic as a lot of foam has been removed. Does that make FDN a buy?
Given all of the above, I am still neutral on this investment vehicle. My skepticism is supported by the ongoing overvaluation problem, as well as its relatively large expense ratio of 51 basis points.
Acknowledging that investors may begin to exultantly increase their allocations to the US tech ladder in search of bountiful (or “generational”) opportunities after the first-half calamities, I still believe it is better to play using larger, cheaper flagship funds, with the Nasdaq 100 (QQQ) and IVV or Vanguard S&P 500 ETF (VOO) taking the top spots on this list.