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Best And Worst Q1’16: Energy ETFs, Mutual Funds And Key Holdings

The Energy sector ranks ninth out of the ten sectors as detailed in our Q1’16 Sector Ratings for ETFs and Mutual Funds report. Last quarter , the Energy sector ranked last. It gets our Dangerous rating, which is based on aggregation of ratings of 23 ETFs and 112 mutual funds in the Energy sector. See a recap of our Q4’15 Sector Ratings here . Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Energy sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 153). This variation creates drastically different investment implications and, therefore, ratings. Investors seeking exposure to the Energy sector should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2. Figure 1: ETFs with the Best & Worst Ratings – Top 5 Click to enlarge * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The Van Eck Market Vectors Uranium+Nuclear Energy ETF (NYSEARCA: NLR ), the PowerShares Dynamic Oil & Gas Services Portfolio (NYSEARCA: PXJ ), and the Van Eck Market Vectors Unconventional Oil & Gas ETF (NYSEARCA: FRAK ) are excluded from Figure 1 because their total net assets are below $100 million and do not meet our liquidity minimums. Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 Click to enlarge * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The Van Eck Market Vectors Oil Services ETF (NYSEARCA: OIH ) is the top-rated Energy ETF and the Fidelity Select Energy Service Portfolio (MUTF: FSESX ) is the top-rated Energy mutual fund. OIH earns an Attractive rating and FSESX earns a Neutral rating. The First Trust ISE Water Index Fund (NYSEARCA: FIW ) is the worst-rated Energy ETF and the Saratoga Advantage Energy and Basic Materials Portfolio (MUTF: SBMBX ) is the worst-rated Energy mutual fund. FIW earns a Dangerous rating and SBMBX earns a Very Dangerous rating. 184 stocks of the 3000+ we cover are classified as Energy stocks. The FMC Technologies (NYSE: FTI ) is one of our favorite stocks held by OIH and earns an Attractive rating. While the Energy market has certainly had its issues over the past two years, FMC Technologies business has continued to exhibit strength. Over the past five years, FMC has grown after-tax profit ( NOPAT ) by 9% compounded annually. The company currently earns a return on invested capital ( ROIC ) of 12%. Best of all, FMC has earned positive economic earnings every year since 2006. Despite the above, FTI declined over 37% in 2015. Now, at its current price of $25/share, FTI has a price to economic book value ( PEBV ) ratio of 0.8. This ratio means that the market expects FMC’s NOPAT to permanently decline by 20% over its remaining corporate life. If FMC can grow NOPAT by just 2% compounded annually for the next decade , the stock is worth $31/share today – a 24% upside. The Diamondback Energy (NASDAQ: FANG ) is one of our least favorite stocks held by SBMBX and earns a Dangerous rating. Despite reporting impressive revenue growth, Diamondback Energy’s business is in decline. The company’s economic earnings have declined from -$32 million in 2012 to -$331 million over the trailing twelve months. Diamondback’s ROIC has fallen from 3% to -2% over the same timeframe. Despite the deterioration of the business, FANG was up 12% in 2015, which has left shares highly overvalued. To justify its current price of $58/share, Diamondback must grow NOPAT by 12% compounded annually for the next 18 years . When contrasted with Diamondback’s short history of value destruction, this expectation appears overly optimistic. Figures 3 and 4 show the rating landscape of all Energy ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs Click to enlarge Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds Click to enlarge Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme.

SPHQ: How Much Quality Is In The ‘High Quality’ ETF?

During bull markets, investors love to chase risky momentum stocks with questionable fundamentals in pursuit of big returns. When volatility increases and markets decline, on the other hand, investors get spooked and start putting more of their money in investments that are perceived as safer and “higher quality.” With the significant drop in the market to start 2016, we can be sure that many investors are looking to shift their portfolios towards higher quality stocks. The challenge is how to define “high-quality” because it is not as straightforward as one might think. ETF investors may view the PowerShares S&P 500 High Quality Portfolio ETF (NYSEARCA: SPHQ ) as an appealing option. After all, the words “high quality” are right there in the name. Over the past six months, SPHQ has seen net inflows of $144 million, nearly triple the cash coming in to the similarly sized SPDR S&P 500 Growth ETF (NYSEARCA: SPYG ). However, investors that truly want to invest in quality stocks need to dig a little deeper. While SPHQ does a better-than-average job of selecting stocks with strong fundamentals, its flawed methodology means investors are getting exposure to some companies with significant weakness in their underlying business. Accounting Earnings Are Unreliable SPHQ tracks the S&P 500 High Quality Rankings Index, which, according to its website , “includes companies rated A- or above based on per-share earnings and dividend payout records for the past 10 years.” As we’ve written about many times before, reported earnings and dividends are not reliable indicators of the underlying quality of a business. High dividend paying stocks can end up being dividend traps, and flawed accounting rules mean that EPS growth has almost no correlation with value creation . Identifying fundamentally sound companies requires more work than just looking at EPS and dividends. SPHQ’s overly simplistic methods allow for some distinctly low quality businesses to find their way into this ETF. Low Quality Businesses In A High Quality ETF The ultimate marker of a high quality business is earning a return on invested capital ( ROIC ) above its weighted average cost of capital ( WACC ). These excess returns drive economic earnings , a far truer measure of profits for equity investors. Figure 1 shows the nine companies in SPHQ that fail this very basic test, having earned negative economic earnings in each of the past five years. Figure 1: SPHQ Stocks With Low-Quality Businesses Click to enlarge Sources: New Constructs, LLC and company filings. General Electric (NYSE: GE ) stands out at the top of Figure 1. The industrial conglomerate has not turned an economic profit since 2006, and its balance sheet is not as strong as it first appears either. $3.5 billion in off-balance sheet debt due to operating leases add to the company’s liabilities. GE has a reputation as a stable business, and the massive sale of GE Capital provides cash to continue serving its 3.2% dividend for many years because the rest of the business is not making money. The firm’s dismal economic earnings prove the underlying business is not nearly as strong as it once was, and the stock’s 8% drop so far this year shows it’s far from safe in a bad market. Utilities make up a good portion of Figure 1, unsurprising for a sector that consistently is near the bottom of our sector ratings . Xcel Energy (NYSE: XEL ) is one of the worst, as it has failed to earn an ROIC above 4% going all the way back to 2002. Even worse, the company has only recorded positive free cash flow once in the past decade. It funds its dividend through taking on more long-term debt, which has ballooned from $7 billion to $17 billion in the past decade. Over $2 billion of that debt is hidden off the balance sheet. Accounting earnings would suggest that XEL is improving, with EPS improving by 6% in the last fiscal year. However, that improvement is almost entirely due to changes in non-operating pension costs, due in part to the company increasing its expected return on plan assets . When we strip out these non-operating items, we see that the company’s true after-tax operating profit ( NOPAT ) declined by 3%. Investors in SPHQ might be surprised to learn that they hold a stake in a company with such a poor track record of destroying shareholder value. Economic Earnings Matter Most In A Tough Market When markets get shaky, it’s not the companies with EPS growth that weather the storm, it’s those that deliver solid economic earnings. Just look at the crash of 2008 . The only stocks that delivered solid returns to investors while the market crashed were those that earned a high ROIC. That is the pattern investors should follow for long-term success in the market. SPHQ is better than a lot of other ETFs out there, and over 75% of its holdings earn out Neutral-or-better rating. Still, its “high-quality” moniker, combined with the lack of diligence involved in selecting its holdings, may mislead some investors. Surviving a market crash is hard. You can’t just trust an ETF’s label and hope your investments will be safe. It takes real diligence and discipline to reveal the true quality of a company’s earnings and measure the strength of its underlying business. We will be the first to tell you that good fundamental research is rare, time-consuming, and expensive. As a result, by the time many investors realize they need fundamental research, it’s too late. Their portfolios have been crushed. We think the recent decline in liquidity is going to lead the market to recognize the true, long-term fundamentals of lots of stocks, a trend that began in 2015 and led to significant outperformance by our Most Dangerous Stocks newsletter as well as many of our Danger Zone picks in 2015. Less liquidity means more natural price discovery, something many experts have warned has been missing for too long. Those same experts have noted that when natural price discovery came back, it could do so with a vengeance. Markets could be volatile for a while. Be prepared. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

How To Avoid The Worst Style Mutual Funds: Q4’15

Summary The large number of mutual funds has little to do with serving your best interests. Below are three red flags you can use to avoid the worst mutual funds. The following presents the least and most expensive style mutual funds as well as the worst overall style mutual funds per our Q4’15 style ratings. Question: Why are there so many mutual funds? Answer: Mutual fund providers tend to make lots of money on each fund so they create more products to sell. The large number of mutual funds has little to do with serving investors’ best interests. Below are three red flags investors can use to avoid the worst mutual funds: Inadequate Liquidity This issue is the easiest issue to avoid, and our advice is simple. Avoid all mutual funds with less than $100 million in assets. Low levels of liquidity can lead to a discrepancy between the price of the mutual fund and the underlying value of the securities it holds. Plus, low asset levels tend to mean lower volume in the mutual fund and larger bid-ask spreads. High Fees Mutual funds should be cheap, but not all of them are. The first step here is to know what is cheap and expensive. To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs below 1.92%, which is the average total annual cost of the 5514 U.S. equity style mutual funds we cover. Figure 1 shows the most and least expensive style mutual funds. Rydex provides four of the most expensive mutual funds while Vanguard mutual funds are among the cheapest. Figure 1: 5 Least and Most Expensive Style Mutual Funds (click to enlarge) Sources: New Constructs, LLC and company filings Investors need not pay high fees for quality holdings. The Calvert Large Cap Core Portfolio (MUTF: CMIIX ) earns our Very Attractive rating and has low total annual costs of only 1.04%. On the other hand, the Fidelity Spartan Mid Cap Index Fund (MUTF: FSMDX ) earns our Neutral rating because it holds poor stocks. No matter how cheap a mutual fund, if it holds bad stocks, its performance will be bad. The quality of a mutual fund’s holdings matters more than its price. Poor Holdings Avoiding poor holdings is by far the hardest part of avoiding bad mutual funds, but it is also the most important because a mutual fund’s performance is determined more by its holdings than its costs. Figure 2 shows the mutual funds within each style with the worst holdings or portfolio management ratings . Figure 2: Style Mutual Funds with the Worst Holdings (click to enlarge) Sources: New Constructs, LLC and company filings Professionally Managed Portfolios appears more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings. Our overall ratings on mutual funds are based primarily on our stock ratings of their holdings. The Danger Within Buying a mutual fund without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on mutual fund holdings is necessary due diligence because a mutual fund’s performance is only as good as its holdings’ performance. Barron’s agrees . PERFORMANCE OF MUTUAL FUND’s HOLDINGs = PERFORMANCE OF MUTUAL FUND Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.