ILCG - ILCG: Don't Chase Tech

2023-09-25 13:29:55 ET

Summary

• ILCG is a tech-skewed ETF thanks to being subsetted to above average growth and being value-weighted within that subset.
• The ETF has a high concentration in tech, with more than 40% of its exposure in the sector, as well as exposure to other high brand-equity and big name stocks.
• The average PE ratio of the ETF is 33x, indicating high valuations, and the PE has remained stable for the top holdings despite changes in the cost of capital narrative.
• We think that equity markets are denying reality with their valuations, a reality that even bond markets in the US are already becoming comfortable with.
• While ILCG is a great asset to know about for a tech and growth factor in the US, we are underweight that factor.

The iShares Morningstar Growth ETF (ILCG) is a heavily tech-skewed ETF, that within its growth subset is value-weighted. We think it's strange that the P/E ratios remain just as high despite the changes in the cost of capital narrative, even acknowledging that new growth expectations have likely been baked in by AI. We think that US tech indices have somewhat overperformed, and there are dual catalysts to the downside of both AI underperformance as well as more entrenched expectations of higher long-term rates, acknowledged already by bond markets but not by equity markets. While we appreciate the ILCG low expense ratio, making it a great tech factor for portfolio building, we just wouldn't be overweight a tech factor right now.

ILCG Breakdown

The exposures are as you'd expect of a tech-skewed ETF focused on US markets. There is a lot of allocation being dedicated to the megacap, trillion-dollar companies, with value-weighted allocations in this high growth subset for the 419 holdings. While subsetted to growth, not just in tech but also other industries, the value-weighted balancing helps keep expense ratios low since you're not paying for any stock picking at all, which is smart for large-cap ETFs since stock picking very rarely adds value.

While other industries are included, the growth subset does mean a lot of the exposure ends up being in tech, more than 40%.

The subset of growth here is defined as stocks with expectations to grow earnings at above the general US market - again a criterion that favors tech and then selects picks from other industries. We notice that in addition to the tech skew, there is a lot of skew generally to companies that have very prominent market positions and often a lot of brand equity.

Bottom Line

ILCG skews towards tech and quality growers in other industries, but their vaunted positions mean that they come with very high multiples. The average PE across the ETF is 33x, which is around the PE of some of the largest holdings, namely Apple ( AAPL ) and Microsoft ( MSFT ).

In addition to the P/E being quite high, we also notice that the P/E has been pretty stable since 2020, despite the dramatic changes in cost of capital expectations as per the bond market , home of smart money. Long-term rate expectations are coming up, and have been for a while, further pushed by the recent clarity on the higher for longer stance being taken by the increasingly hawkish central banks. Inflation hasn't come down quickly enough.

Long-term rates have the biggest impact (or at least they should) on tech and other high multiple valuations. High multiples mean a lot of weight is being given to distant expectations that are discounted by longer-term rates. Since those rates are compounded into discount factors, increased bases have a huge impact on the valuation of horizon values. High multiple stocks are very sensitive to horizon value in their valuation models to imply the absolute multiples.

The higher for longer stance was quite predictable, and in recent months, especially when this odd soft landing narrative took massive hold, we'd been focused on the fact that it was the most likely outcome. The first reason is that the last leg of inflation after the conclusion of base effects was going to be more stubborn. On a secular term, deglobalization is a major factor that creates an inflationary pressure and raises longer-term rate expectations. Increasing rather than decreasing economic nationalism virtually assures that deglobalization will be an enduring factor for rate expectations.

Bond markets are still coming to terms with higher long-term rates, but at least they made some headway in acknowledging the situation. In the meantime, equity markets have entirely ignored higher long-term rates. The gap between the equity and bond market interpretation of the situation is only widening, and we think that tech will take an outsized hit once reality takes hold of equity market valuations.

We acknowledge that AI has presented opportunities for many tech and growth stocks, but we also believe that a disillusionment is coming in the medium term and that will be another catalyst to trigger more rational valuations in tech, in addition to the cost of capital and other valuation concerns. In particular, we also worry about severe blowback against AI development from many incumbent groups, including content companies, labor unions and other powerful political entities.

While ILCG is a lovely ETF as a tech and growth factor, thanks in large part to the fact that it's a growth exposure you can obtain for very economical rates with an expense ratio of just 0.04%, we are underweight tech at the moment, as well as being underweight the US, and will entirely eschew these markets for the foreseeable future.

For further details see: