How to value thematic strategies

Mar 8th, 2021 | By | Category: Equities

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By Matthew Bartolini, Head of SPDR Americas Research at State Street Global Advisors.

Matthew J Bartolini, Head of SPDR Americas Research

Matthew Bartolini, Head of SPDR Americas Research.

During the pandemic, we’ve seen an evolution of behavioral changes fuel transcendent trends across our economy that may create new future growth opportunities.

This has spurred investor interest in thematic ETFs that seek to provide exposure to firms at the forefront of innovation. In 2020, more than $40 billion flowed into ETFs focused on Future Communication, Clean Energy, Smart Transportation, and Cloud Computing.

To formulate a fundamental view on these areas of innovation, it is important to consider which valuation metric may be the most appropriate.

Fundamentally thematic

Selecting the most appropriate metric requires understanding the type of firms typically found in the 145 funds we identify as thematic strategies. Our security look-through analysis finds many of these funds are concentrated in the Consumer Discretionary, Health Care, and Information Technology sectors. Importantly, the firms in those sectors typically have significant intangible assets on their balance sheets. Price-to-book may not be the best metric here because high intangible assets usually understate a firm’s book value—potentially inflating the firm’s price-to-book measure.

Earnings-related issues for thematics

There is an issue, however, if we use earnings-related metrics (e.g. price-to-earnings (P/E), price-to-next-12-month-earnings, and enterprise value-to-EBITDA). First, negative earnings firms must be removed, resulting in an incomplete exposure being analyzed. And those firms must be removed so as not skew the result (i.e., negative P/E values would tamp down the high P/E values when performing an average calculation for a portfolio).

The presence of negative earnings firms in some thematic exposures means any multiple that has earnings-related information in the denominator should not be utilized. This also holds true for the price-to-earnings-growth ratio (PEG), since it still relies on earnings in the denominator, while normalizing the ratio by expected growth.

No earnings, but revenue, hopefully

While some innovative firms do not have earnings, they likely have sales/revenue. Therefore, using one of these two sales-based metrics may be more optimal: price-to-sales and enterprise value-to-sales. The latter, in my opinion, offers the most appropriate and comprehensive view of a firm’s operations, as enterprise value (EV) accounts for both the firm’s equity value and amount of debt. Accounting for the level of leverage/debt utilized by the firm to generate revenue, it tends to be more comparable across industries, given it is capital structure agnostic (i.e., high-debt industries typically look cheaper on a price-to-xyz basis since their debt isn’t captured in the metric, but under EV, the debt is taken into account).

A list of metrics — and the strengths and drawbacks of thematic valuations — are shown below:

The table below compares the different metrics for an aggregated portfolio of all 18 Broad Innovation funds with the broad S&P 500. The average figure for the Broad Innovation category is higher than the broad market — as would be expected. However, when it comes to enterprise value-to-sales, the skew is much tighter, due to dynamics discussed above.

While these exposures were trading rich at the end of last year, the multiples are elevated to the broader market due to higher expected growth estimates and the potential for behavioral changes to create future growth opportunities.

Analysis in 2021 and beyond

The pandemic will continue to spark a greater need for innovative technologies that allow for more contactless interactions, advanced medicine, digital connectivity, and intelligent infrastructure.

With more ways to participate in these thematic trends, investors need a classification framework as the first step in due diligence.  It’s also important to understand the construction approaches for each exposure. Of all the valuation multiples available, enterprise value-to-sales may be the most appropriate.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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