ETF Pair Trade To Navigate Shifty Tech Stocks

Market volatility is not going anywhere soon, and Technology stocks are often the most volatile.

I have an ETF pair trade (i.e. long/short  strategy) for investors who want to maximize upside potential and minimize downside risk in Technology stocks.

One often-overlooked advantage to ETFs is that we know their holdings and allocations every day. Mutual funds often take weeks or months to disclose their holdings. Many articles have been written about how that lack of transparency allows mutual fund managers to window-dress their holdings at the end of reporting periods. That is not possible with ETFs.

My bottoms-up analysis of ETFs based on their holdings drives my predictive ratings (defined here) on ETFs. These ratings allow investors to know more about the relative merits of ETFs.

As I have shown in my Best & Worst ETFs articles, you cannot trust ETF labels. We cover 28 ETFs and they hold anywhere from 21 to 376 stocks. That wide range means the performance of the ETFs is likely to be very different. My free ETF screener provides my ratings and reports on all 28 Tech ETFs.

Further, some tech ETFs hold good stocks and others do not.  Per Best & Worst ETFs & Mutual Funds: Technology Sector, investors need to tread carefully when considering Tech ETFs. Only eight out of twenty-eight get and Attractive rating and are worth buying because they allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating.

Part of the reason so few Tech ETFs get an Attractive-or-better rating is that there are not many good Tech stocks to choose from. 44% of the 546 Tech stocks I cover are rated Dangerous or worse. 74% are rated Neutral or worse. My stock ratings are defined here.

The ETF pair trade I propose maximizes the value of my research for clients by identifying the very best ETF to be long, Technology Select Sector SPDR [s: XLK], and the very worst ETF to be short, PowerShares Lux Nanotech Portfolio [s: PXN]. If that ETF is not liquid enough to short, my recommended alternative is First Trust DJ Internet Index Fund [s: FDN].

XLK gets my Attractive rating because it allocates 64% of its value to Attractive-or-better rated stocks. Only 12.5% of the portfolio is in Dangerous-rated stocks and nothing is in Very Dangerous-rated stocks. XLK also has a low expense ratio of 0.18%, better than 89% of all ETFs.

On the other hand, PXN and FDN charge 0.66% (higher than 70% of ETFs) or 3.5 times as much as XLK – and – they are in much lower quality stocks. PXN allocates nearly 50% of its portfolio to Dangerous-or-worse-rated stocks. FDN allocates over 40% to Dangerous-or-worse-rated stocks. Both allocate only about 27-28% to Attractive-or-better-rated stocks. PXN gets my Dangerous rating. FDN gets my Neutral rating.

This pair trade gives investors exposure to the best that Tech ETFs offer and minimizes risk of loss by shorting the worst that Tech ETFs have to offer. Win win.

My favorite stock in XLK is Apple [s: AAPL]. I remain amazed that so few have focused on the most important driver of its stock price: the company’s 270% return on invested capital (ROIC). As detailed in “Apple Bears Have It Wrong”, Apple represents the best of corporate America because of its elite level of profitability. A 270% ROIC means that the company generated, in 2011, $2.70 of after-tax cash flow (NOPAT) for every dollar of capital put into the business over its life. In other words, Apple generated enough cash flow to pay off its original investors 2.7 times in one year. In 2010, Apple’s ROIC was 206%.

At the same time, the stock is cheap and implies astonishingly low profit growth. At $570/share, the current valuation suggests that Apple will grow its NOPAT by only 30% In fiscal year 2012. Consensus for EPS growth is over 60% this year (2012) and around 15% for 2013. If Apple grows its NOPAT by 15%, compounded annually, for 3 years, the stock is worth north of $700.

My least favorite stock held by FDN or PXN is [s: AMZN]. Amazon is an excellent example of a good company but a bad stocks. By good company, I mean that it is respectably profitable and has a decent ROIC of 12% (ranks in the 2nd quintile). By bad stock, I mean that it is too expensive. The cash flow expectations embedded in $215/share for AMZN are 25% NOPAT growth compounded annually for 12 years. Those are some seriously high expectations for a company in as competitive a business as retail.

Disclosure: I am own AAPL. I receive no compensation to write about any specific stock, sector or theme.

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