SPY - IWY: Should You Buy Large-Cap Growth Stocks?

2023-03-20 04:03:00 ET

Summary

• IWY is a concentrated large-cap growth ETF, selecting from the top 200 stocks in the Russell 1000 Index. Fees are 0.20% and the fund has nearly $5 billion in assets.
• IWY trades at 28x forward earnings and has only a marginally higher earnings growth rate than SPY. All three screens are backward-looking, a potential flaw with this historically top-performing ETF.
• Market sentiment, evidenced by weak earnings surprises and analyst earnings revisions, remains poor. A higher margin of safety is required with a richly-valued ETF like IWY.
• While I don't recommend investors buy IWY today, this article presents its fundamentals alongside QQQ and SPY.

Investment Thesis

The iShares Russell Top 200 Growth ETF ( IWY ) is a top-performing large-cap growth ETF with a significant valuation problem that makes it unwise to buy today. As in previous reviews, this article highlights IWY's excessive 28x forward earnings valuation and notes a deteriorating earnings growth rate brought on by recession fears. Therefore, a higher margin of safety is still needed, and I look forward to taking you through the latest numbers below.

IWY Overview

Strategy and Fund Characteristics

IWY tracks the Russell Top 200 Growth Index, selecting 200 companies from the Russell 1000 Index by the following three factors:

1. Three-year change in earnings per share over the current share price
2. Three-year sales per share growth rate
3. One-year price change

All factors are backward-looking, which isn't my preferred approach. This article supplements with forward-looking metrics, which may be more helpful in fast-changing environments.

iShares lists the following fund characteristics on its website. IWY has $4.89 billion in net assets, a 0.20% expense ratio, and is liquid, indicated by a low 0.03% median bid-ask spread. The ETF structure provides a secondary source of liquidity that investors sometimes dismiss, explained here . Still, it's one of the cheapest ways to own a dedicated basket of large-cap growth stocks, and as we'll see shortly, it also has an excellent long-term track record.

Performance Analysis

IWY launched on September 22, 2009, shortly after the end of the Great Financial Crisis. It hasn't experienced many significant headwinds. However, IWY has yet to fully recover from its 30.68% drawdown between January and September 2022. It remains 24.24% underwater compared to 16.71% for the SPDR S&P 500 ETF ( SPY ). Growth ETFs like IWY work well when market sentiment is positive, but investors must identify when the fundamentals no longer support that sentiment. The absence of valuation screens, while not the focus for growth funds, can be detrimental.

The following graph highlights the peak before the January 2022 drawdown. For the three years ending December 2021, IWY and SPY had annualized returns of 35.38% and 25.99%, respectively. The Invesco QQQ ETF ( QQQ ) performed even better at 37.99%. Even without assessing the fundamentals, most understand these returns are unsustainable. The subsequent decline was swift, and less-volatile ETFs that considered valuations outperformed. For the three years ending February 2023, annualized returns are around 12-13% for all three ETFs, a much more sustainable level.

Finally, consider the following periodic returns for 25 large-cap growth ETFs with at least three years of history. Returns are through February 2023 and highlight how IWY was the third-best long-term performer, gaining 301.15% over the last ten years.

The Invesco S&P 500 GARP ETF ( SPGP ) also performed well, gaining 309.80% over the last decade and significantly outperforming over the previous three years. It's one of the few growth ETFs that consider valuation. My cautionary note is that its Index has changed several times since its launch, so long-term returns may be deceiving. You can read my latest review on the ETF here .

IWY Analysis

Sector Exposures and Top Ten Holdings

Sector exposures for SPY, QQQ, and IWY are listed below, highlighting how the latter two rely heavily (50%) on the Technology sector. It's not surprising in IWY's case, given its reliance on historical growth metrics. However, these allocations may not continue going forward. My analysis of SPDR Sector ETFs reveals that Energy exposure will likely increase over the next few years. Exxon Mobil ( XOM ) and Chevron ( CVX ) are ranked #10 and #17 in the S&P 500 Index and have three-year earnings growth rates of 58% and 128%.

IWY and QQQ have similar exposures, but QQQ has 2.80% more in Meta Platforms ( META ) and includes six other companies in the sector, including T-Mobile US ( TMUS ), Comcast ( CMCSA ), and Activision Blizzard ( ATVI ). The top ten holdings total 54.73% and are listed below. Apple ( AAPL ) and Microsoft ( MSFT ) combine for 28.64%, while Alphabet's two share classes total 6.35%. Other mega-caps include Amazon ( AMZN ), Tesla ( TSLA ), and UnitedHealth Group ( UNH ).

Fundamentals vs. QQQ, SPY

Concentrated ETFs like IWY are inherently riskier than broad-based funds since a relatively small number of companies drive returns. In IWY's case, 73.01% of the portfolio is in its top 25 holdings and 90.18% in its top 25 industries. QQQ is similar, while SPY is the better-diversified option. Generally, growth ETFs are more concentrated than value ETFs due to the impact of mega-caps.

The above table highlights some areas of concern. IWY has an estimated 9.58% and 9.18% sales and earnings growth rate, about six percent less than the last three years (15.94% and 15.31%). Assuming these rates materialize, it's unreasonable to expect the huge returns of the previous decade. IWY trades at 28.22x forward earnings, 5.26 points more expensive than SPY, with marginally higher expected growth. The key culprit is Apple, with an estimated 5.67% earnings growth rate compared to the 18.27% historical three-year figure. These stark differences illustrate why investors should consider forward-looking metrics, too. They may not prove accurate but are likely more reasonable approximations in the current environment.

Apple and Microsoft also have poor earnings momentum, as illustrated by their poor EPS Revision Scores of 3.08/10 and 2.31/10. IWY's weighted-average score of 4.55/10 is slightly better but lower than alternatives like QQQ and SPY. These poor scores indicate negative market sentiment, and they've consistently fallen over the last year. One reason is that company earnings reports aren't providing analysts with a reason for excitement. Notice IWY's weighted-average -0.06% sales surprise figure last quarter, again, led by these top two holdings.

On the earnings side, Yardeni Research highlights the troubling trend of decreasing earnings surprises among S&P 500 Index companies. After reporting double-digit positive surprises when markets substantially rose in 2020-2021, they're below the long-term 5-7% average. Investors switching from growth to value stocks in 2022 were rewarded, which I believe remains the correct approach.

On a positive note, it's hard to argue against its quality. IWY's 9.83/10 Profitability Score is category-leading. QQQ's 9.77/10 score is the third-best of the 25 growth ETFs listed earlier, with the Invesco ESG NASDAQ 100 ETF ( QQMG ) coming in second place. Profitability is an excellent screen for long-term investors, and although I don't suggest buying either ETF today, I doubt you will go wrong in the long run.

Investment Recommendation

IWY trades at 28x forward earnings and has only a marginally higher estimated earnings growth rate than SPY, making it too risky to buy today. Key companies like Apple and Microsoft need to provide analysts with reasons to upgrade earnings estimates, and until that happens, growth stocks will remain under pressure. Therefore, I recommend investors avoid IWY at this time. Thank you for reading, and I look forward to answering any questions in the comments section below.

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