QUAL: Big-League Momentum, But The Valuation Is Just Too Rich (BATS:QUAL)

Are megacap tech stocks eating the world? It sure feels that way, right? The Magnificent Seven US equities continue to power higher, and the exclamation point was made earlier this week when Microsoft (MSFT) topped $3 trillion for the first time. The S&P 500 now has a pair of $3 trillion-sized companies. But what if I told you that another area of the market was getting in on the bullish action? And it is not a growth-style pocket. The Financials sector has beaten the SPX over the past three months, along with Tech. Those are the two biggest sector weights in one smart-beta fund.

I have a hold rating on the iShares MSCI USA Quality Factor ETF. I very much like the quality tilt that helps to generate healthy long-run risk-adjusted returns, but its valuation today appears stretched.

Tech & Financials Team Up, Outperforming the S&P 500

According to the issuer, QUAL seeks to track the investment results of an index composed of U.S. large- and mid-capitalization stocks with quality characteristics as identified through certain fundamental metrics. The ETF offers investors exposure to stocks exhibiting positive fundamentals such as high return on equity, stable year-over-year earnings growth, and low financial leverage), per iShares.

QUAL is a large ETF with more than $37 billion in assets under management and it pays a small 1.2% dividend yield as of January 24, 2024. Its annual expense ratio is low at 15 basis points. Share-price momentum has been extremely strong over the last several months, helping the fund to earn a pristine A+ ETF Grade by Seeking Alpha. Overall, QUAL ranks number 3 out of 180 in its ETF Sub Class as the first quarter presses on. Its factor orientation has also led to impressive risk-adjusted returns, helping the fund to an A+ Risk Grade, too. Finally, liquidity is healthy given the ETF’s average trading volume of 1.49 million shares over the past three months and a 30-day median bid/ask spread of just a single basis point.

Digging into the portfolio, QUAL is primarily a large-cap portfolio with just 18% of the allocation considered mid-cap. The 4-star, Silver-rated ETF by Morningstar is priced between 22- and 23-times earnings. With strong momentum and a tilt to growth, I found that this P/E ratio is historically high. Notice in the earnings multiple graph below that QUAL normally trades at a slight valuation premium to the market, but today’s P/E has turned stretched, particularly considering that interest rates are markedly higher now versus the average of the mid to late 2010s. The current PEG ratio is lofty around 2.

QUAL: Portfolio & Factor Profiles

QUAL P/E Ratio History

Driving the valuation higher is a significant weight to the Information Technology sector. At more than 31%, It’s about 1.3 percentage points above the weight in the SPX. Financials and Health Care command the next highest position. In all, the top 10 assets comprise a moderate 38% of the total ETF. So, diversification is decent but not overly strong with this portfolio given the high weight to TMT stocks.

QUAL: Holdings & Dividend Information

Seasonally, QUAL tends to trade sideways from late January through the end of the first quarter. The real gains in its 10-year performance history come at the start of Q2 and persist through August, according to data from Equity Clock. So, bouts of volatility over the next handful of weeks should be seen generally as buying opportunities per historical trends.

QUAL: Neutral Q1 Seasonal Trends, Strong Q2

The Technical Take

QUAL is up about 50% from its October 2020 low. It has been a wild ride in the last three years, though. Notice in the chart below that shares peaked in late 2021 and early 2022 between $146 and $147. A significant decline on the order of 30% ensued, with QUAL falling below its key 200-day moving average. 2023 was a fantastic year, and the hold major hiccup was a garden-variety correction from late July through late October. That pullback of nearly 10% was met with intense buying enthusiasm at the rising 200dma. Shares zoomed into the end of the year and have rallied to fresh all-time highs as we approach the end of January – that is undoubtedly bullish in the eyes of technicians.

Given the height of the previous range, from $102 to $147, a measured move price objective to $192 is in play, and there is no resistance in the form of a supply of shares up to that level. There is, however, an ample amount of volume by price beginning in the mid-$140s with long-term support likely at the 200dma.

Overall, the chart and momentum conditions are strong, helping to offset the high valuation.

QUAL: Bullish Long-Term Breakout, Rising 200dma

The Bottom Line

I have a hold rating on QUAL. Its technical setup is robust, but the valuation should be a concern to long-term investors right now. Buying on a pullback this year is likely the way to play it.