FDN: More Realistic Valuations, Growth Prospects Trimmed

This year, the global equity markets have been in dire straits. Well, some more than others.

The 2010s were at times called a ‘value winter’ or a ‘value drought,’ opinions vary. Then the tables turned. 2022 to date was more of a ‘growth drought,’ to tech investors’ chagrin. It was the high-multiple tech (defined broadly) and especially speculative tech cohort that bore the brunt as investors were hastily removing growth premia from the equity valuations, selling incessantly and at times hysterically, preparing for an era of higher rates for longer, scarcer capital, and subsequently weaker growth.

In my article on the First Trust Dow Jones Internet Index ETF (NYSEARCA:FDN) published on 31 December 2021, I warned my dear readers that going long tech names, regardless of whether they are of the bellwether league of mid-caps, was a dire decision at that point. And I was right. It was fairly simple to foresee this outcome. The tech carnage was in the cards as two factors conflated. They were too expensive (as I illustrated using the Quant data) and the interest rate increases by the Fed looked entirely certain, even though the magnitude was not yet known and inflation was not that rampant, so there were hopes that smaller hikes would be enough to quell it, and the repercussions of tightening would be limited both for Main Street and Wall Street.

If investors would ask what investment vehicle lost close to all of its pandemic premium (the ultra-loose monetary policy tailwinds, record liquidity, stay-at-home economy, etc.), FDN is an example that immediately springs to mind.

The ETF has seen its price slumping this year almost incessantly, now trading around the April 2020 level. At some point in June, it was seemingly up to testing the March 2020 low.

For quite some time, investors were pointing out that trends that gained momentum during the pandemic are secular, yet this did not save growth portfolios from the shrinkage of multiples. And FDN’s peers targeting similar or adjacent themes have certainly not emerged unscathed. Specifically, this year has been a sheer calamity for the ARK Innovation ETF (ARKK).

This is a perfect encapsulation of a phenomenon when secular trends that are supposed to reshape the modern economy completely over the course of the decades (AI and robotics, fintech, the sprawling EV universe, etc.) meet the new harsh reality of the monetary policy turn. Valuation matters.

Below is the comparison of total returns of a few selected growth-and innovation-centered 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 up to July to the iShares Core S&P 500 ETF (IVV).

As can be seen, though losses have been mounting in H1 2022, bright spots have emerged recently. July was the month when the tech-heavy portfolios staged a recovery, though the magnitude of the rebound varies across the board, with FDN delivering the third-largest improvement in the selected peer group.

In this regard, the major question right now is whether FDN became a Buy after the H1 slump and the impressive July recovery. Did valuation become more realistic? And what happened with growth rates? Are there any other risks to consider? Let us dig in.

Material changes: valuation becoming more realistic, momentum unsurprisingly wanes

Certainly, the FDN portfolio has undergone changes since my previous note, and not only in terms of composition. Factor exposures have also shifted, and a few even meaningfully.

To recap, this First Trust ETF invests in long-term growth unapologetically. Its equity basket mirrors the Dow Jones Internet Composite Index, the benchmark drawing its forty components from internet commerce (15 constituents) and internet services (25 constituents), the two industries poised to benefit from strong secular trends.

Since December, despite quarterly rebalancing, the structure of the FDN portfolio has remained almost homogenous, with just minor additions and deletions. For example, Opendoor Technologies (OPEN) managed to qualify for inclusion, now accounting for 0.6% of the net assets, while Wayfair (W) and Vonage Holdings (traded with a ticker VG on Nasdaq) were removed (an approximately 2% combined weight). VG was acquired by Ericsson (ERIC).

What has changed profoundly is the factor exposure, which is succinctly described by the chart summarizing the Quant data below. To clarify, ‘Relatively undervalued’ is for stocks with a Quant Valuation grade 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 internet stocks’ equity valuations were ballooning for years, as investors envisioned unhindered growth to continue, but 2022 put a period on that. As you can see, the share of overvalued companies fell to ~67%, while those priced attractively gained.

At the same time, we see a small decline in exposure to growth leaders, while growth laggards seized a larger share of the net assets. Once again, this is more likely a direct effect of the growth premia shrinkage.

Next, quality even improved, though marginally, with the most profitable stocks now accounting for 87.5%.

As the FDN holdings suffered badly, momentum expectedly wilted. The share of top momentum stocks plunged by a massive 26%.

And finally, Wall Street curbed its enthusiasm, making realistic adjustments to tech earnings, as the share of stocks with at least B- EPS Revisions grades is now lower by a fifth.

Another chart allows judging how the portfolio has evolved from yet another angle. This is the summary of the holdings’ growth prospects, manifested in the forward EBITDA and revenue growth. V, VG, OPEN, as well as a few other stocks that had no analyst consensus EBITDA estimates in December, were removed; overall, the chart covers 31 stocks or almost 80% of the portfolio. Red dots are for the end-2021 figures.

As you can see, a lot of optimism evaporated. Outliers like Zoom Video Communications (ZM), Pinterest (PINS), and Datadog (DDOG) have seen their growth rates cut mercilessly.

To bring a bit more color, here are the same datasets wrapped in a different chart. A slew of downward revisions becomes even more vivid.

The takeaway? 2022 has been a rude awakening for investors and analysts. Valuations became more realistic as a lot of froth was removed. Does that make FDN a Buy?

Final thoughts

Considering all of the above, I am still neutral on this investment vehicle. My skepticism is undergirded by the persisting overvaluation problem, together with its comparatively large expense ratio of 51 bps.

Acknowledging that investors may start exultantly topping up their allocations to the U.S. tech echelon seeking generous (or ‘generational’) opportunities after the calamities of the first half of the year, I am still of the opinion that this is better to be played using larger, cheaper bellwether funds, with the Nasdaq 100 (QQQ) and IVV or the Vanguard S&P 500 ETF (VOO) occupying the leading positions on this list.