Applying Benjamin Graham’s Principles to ETF Selection

Content provided by Allan Lane PhD

Constructing Trading Signals with Fundamental Data

When Benjamin Graham wrote ‘The Intelligent Investor’, he likely wasn’t thinking about ETFs - they didn’t even exist. Yet, his core principles of value investing are remarkably adaptable to the modern world of ETF selection. With the growing accessibility of ETFs and their role in providing diversified exposure to markets, the question becomes: how can we construct trading signals using fundamental data that align with Graham’s philosophy?

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Let’s start by revisiting Graham’s core ideas and explore how we can modernize them with the help of insights from modern financial insights and techniques.

What Would Benjamin Graham Say About ETFs?

Graham emphasized three principles: the ‘margin of safety’, the use of ‘intrinsic value’, and the importance of ‘defensive investing’. In the context of ETFs, these translate into:

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1. Margin of Safety: Select ETFs that appear undervalued based on fundamental metrics like price-to-earnings (P/E) or price-to-book (P/B) ratios.

2. Intrinsic Value: Look at the weighted average valuation of an ETF’s holdings to determine whether it’s priced fairly relative to its underlying assets.

3. Defensive Investing: Prioritize diversified ETFs with solid fundamentals to protect against downside risk.

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In essence, Graham might have advised building a framework to systematically evaluate ETFs using the fundamentals of their underlying securities. But which metrics should we use, and how can we construct meaningful trading signals?

The Fundamental Metrics That Matter

Modern financial insights provide a broad perspective on the fundamental metrics that investors can use, combining Graham’s classic methods with techniques tailored for to today’s investment landscape. Valuation metrics such as price-to-earnings (P/E) ratios remain a cornerstone, helping identify ETFs whose underlying holdings are undervalued relative to their earnings potential. Forward P/E ratios are particularly useful tools for forecasting long-term returns. Similarly, price-to-book (P/B) ratios are invaluable for evaluating ETFs focused on asset-heavy sectors like financials or industrials. Dividend yields, another favourite of Graham’s, continue to play a role in signalling income potential and relative undervaluation within ETFs.

Beyond valuation, profitability metrics provide deeper insights into the financial health of an ETF’s underlying holdings. Return on equity (ROE), for instance, highlights quality companies with sustainable advantages, while operating and net profit margins offer a snapshot of efficiency and stability, particularly in sectors such as technology and consumer staples. Growth metrics like earnings and revenue growth are increasingly vital for selecting ETFs in high-growth sectors, including emerging markets and technology.

Risk metrics further round out the toolkit for ETF evaluation. Debt-to-equity ratios reveal the leverage levels of an ETF’s holdings, signalling resilience during market downturns, as do the strength of a balance sheet and stability of earnings. Meanwhile, measures of volatility, such as beta, although not strictly fundamental, complement defensive strategies by indicating relative risk.

By thoughtfully combining these metrics, investors can construct robust trading signals to systematically evaluate ETFs.

The Underperformance of Value as an Investing Style

While valuation metrics like P/E and P/B ratios have long been staples of investment analysis, it is essential to acknowledge that value investing as a style has struggled in recent years. Over the past decade, growth stocks - often characterized by high earnings growth and steep valuations - have significantly outperformed value stocks. This trend has been fuelled by technological innovation, low interest rates, and investor preference for companies with disruptive potential.

ETFs focused on value strategies have, as a result, lagged behind those targeting growth sectors like technology. Investors relying heavily on traditional value signals may have found fewer opportunities for outperformance. However, this does not render value metrics obsolete. Instead, it underscores the importance of adapting Graham’s principles to contemporary market conditions. Blending value metrics with growth and profitability indicators may offer a more balanced approach, capturing the best of both worlds.

Furthermore, it is worth noting that investing styles often move in cycles. The underperformance of value may reverse as market conditions shift, such as during periods of rising interest rates or economic recovery, when undervalued companies typically gain favour. Thus, while value may not have shined recently, its core principles remain a critical component of a diversified investment strategy.

Building a Graham-Inspired ETF Trading Signal

Constructing a trading signal grounded in Graham’s principles involves several steps. First, clearly define the objective: are you seeking undervalued ETFs, high-growth options, or income-focused funds? Once the goal is set, gather the fundamental data from tools or platforms that provide weighted averages of ETF holdings. Metrics such as forward P/E ratios and dividend yields are typically available in ETF fact sheets or financial databases.

Next, create a composite score by assigning weights to the chosen metrics. For example, a value-focused signal might allocate 40% weight to P/E, 30% to P/B, and 30% to dividend yield. Normalize and rank ETFs based on their composite scores. Finally, backtest the signal against historical performance to assess its effectiveness and refine it as necessary.

Modern Insights on ETF Selection

Innovative metrics beyond Graham’s original framework offer valuable tools for ETF selection today. Thematic exposure, for example, has become an important consideration. ETFs aligned with megatrends such as clean energy or artificial intelligence provide opportunities for long-term growth, adding a forward-looking dimension to traditional analysis. Sector and geographic insights also play a crucial role in the decision-making process. Regional ETFs can be evaluated based on macroeconomic indicators like GDP growth or inflation expectations, while sector ETFs might be assessed using specialized metrics such as R&D spending or profit margins.

Another modern metric worth considering is the earnings yield spread. By comparing the earnings yield of ETFs (inverse of P/E) with bond yields, investors can identify relative value opportunities, especially in uncertain economic environments.

Practical Examples

iShares Russell 2000 ETF - The iShares Russell 2000 ETF (IWM) is designed to track the performance of the Russell 2000 Index, which is a benchmark for small-cap stocks in the United States. The Russell 2000 Index is composed of the smallest 2,000 companies in the Russell 3000 Index, which is a broader index that includes the largest 3,000 companies in the US stock market. As of August 2021, the Russell 2000 Index included approximately 2,000 stocks, and the iShares Russell 2000 ETF held a portfolio of over 2,000 small-cap stocks. The ETF seeks to provide investors with exposure to the small-cap segment of the US equity market, which is known for its potential for growth but also its higher volatility compared to larger-cap stocks.

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Vanguard Value ETF - The Vanguard Value ETF (VTV) tracks the CRSP US Large Cap Value Index. This index is designed to measure the performance of large-cap value stocks in the US equity market. As of the latest data, the index comprises approximately 300 stocks, focusing on companies that exhibit value characteristics, such as lower price-to-earnings ratios and lower price-to-book ratios compared to the broader market. The composition of the Vanguard Value ETF includes a diverse range of sectors, with significant allocations typically found in financials, healthcare, consumer goods, and energy. This diversification helps to mitigate risk while providing exposure to companies that are considered undervalued relative to their fundamentals. Investors in VTV gain access to a portfolio that emphasizes value investing, which can be appealing during various market conditions, particularly when growth stocks may be underperforming. The ETF aims to provide long-term capital appreciation and income through dividends, making it a suitable option for those looking to invest in value-oriented equities.

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Invesco QQQ Trust - The Invesco QQQ Trust, also known as QQQ, is an exchange-traded fund (ETF) that tracks the performance of the Nasdaq-100 Index. The Nasdaq-100 Index includes 100 of the largest non-financial companies listed on the Nasdaq Stock Market. These companies come from various sectors such as technology, healthcare, consumer discretionary, and more. The QQQ ETF aims to provide investors with exposure to the performance of these 100 companies. It is designed to replicate the price and yield performance of the Nasdaq-100 Index. The index is weighted by market capitalization, meaning that larger companies have a greater impact on the index's performance. As for the number of stocks in the index, the Nasdaq-100 Index consists of 100 stocks. Therefore, the Invesco QQQ Trust also holds 100 stocks in its portfolio, representing the constituents of the index.

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To illustrate these concepts, consider three scenarios with the specific US-listed equity ETFs, described above, that have been popular and amassed significant assets under management over the past decade. First, for a value-focused approach, ETFs like the Vanguard Value ETF (VTV) can be screened for a P/E ratio below historical averages, a dividend yield above 2%, and a low P/B ratio relative to peers. VTV provides broad exposure to US large-cap value stocks and is known for its consistency in tracking value-oriented metrics. Over the past year, its P/E ratio has fluctuated between 18 and 22, reflecting shifts in market valuations of its underlying holdings. These fluctuations highlight the dynamic nature of value investing and its responsiveness to economic and market conditions. By maintaining a relatively stable range, VTV underscores its appeal as a reliable choice for value-focused investors, particularly when compared to other value ETFs with greater variability.

For growth opportunities, the Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100 Index, exemplifies ETFs with earnings and revenue growth rates exceeding 10% and an ROE above 15%. QQQ is heavily weighted toward technology and other high-growth sectors, making it a prime candidate for growth-oriented strategies.

Lastly, for investors seeking exposure to a specific segment of the US equity market, the iShares Russell 2000 ETF (IWM) provides a compelling option. IWM tracks the Russell 2000 Index, which represents small-cap US companies. These companies often exhibit higher growth potential compared to large-cap firms, albeit with increased volatility. Traditional value signals like P/E and P/B ratios may be less effective for evaluating IWM, as small-cap stocks often trade at higher multiples due to growth expectations and reinvestment into expansion. Over its long history, IWM has attracted significant assets under management due to its ability to capture the performance of the US small-cap sector. Its holdings offer investors access to a diverse range of industries and a dynamic growth-oriented investment approach, making it a distinctive choice for those looking to balance growth and diversification.

Challenges and Considerations

While fundamental data is powerful, it has limitations. Not all ETFs provide granular transparency into their holdings, making data quality a critical factor. For instance, some ETFs aggregate holdings across sectors or geographies in ways that obscure detailed financial metrics, making it challenging to apply valuation signals effectively. Additionally, sector biases can skew results; value metrics often favour financials or industrials over technology sectors, which are typically growth-oriented and less reliant on traditional valuation measures like P/E ratios. This creates potential blind spots when evaluating ETFs with diversified holdings.

Another significant challenge is the risk of overfitting signals to historical data. Backtesting trading signals against past performance may yield overly optimized results that fail to generalize to future market conditions. To mitigate this, it is essential to stress-test models across varying market environments and to consider out-of-sample testing. Moreover, factors like liquidity and expense ratios, while not purely fundamental, play an essential role in the practical application of ETF trading strategies, as they can significantly impact returns.

The Conclusion – When Reality Bits

Blending Benjamin Graham’s timeless principles with insights from modern techniques allows investors to create sophisticated trading signals for ETF selection. Whether focusing on undervalued ETFs, growth opportunities, or thematic relevance, fundamental data offers a solid foundation for disciplined decision-making. As Graham might say, while the tools evolve, the principles of sound investing remain constant.

Much has been written about the effectiveness of Value Investing, but since the default of Lehman Brothers on 15th September 2008, the fund management industry has been reshaped by the surge of interest in growth stocks.? With the Nasdaq 100 Index vastly outperforming both the Russell 2000 Index and the CRSP US Large Cap Value Index, any investment manager if they were on the wrong side of that divide will have been left behind.

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With the onset of AI euphoria sweeping through all business sectors, particularly in the form of AI Agents that many commentators expect will bring 10X efficiencies to the bottom line, there is every reason to believe that in the future the assessment of a company’s value will need to be looked at through a different lens.?

Whether Benjamin’s Graham’s disciples will continue to fly the flag, only time will tell, but it does feel like that, at the aggregate level, the rules of investing might have changed forever.?

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