SCHG - SCHG: The Apple Risk

2023-11-13 22:57:34 ET

Summary

• Apple's weight in the ETF may be a hindrance to its performance.
• SCHG has an estimated EPS growth of 15% in the YE24-25 period.
• The valuation of the ETF is a headwind, with a high P/E ratio of 23x and a PEG ratio of 1.8.

Summary

Schwab U.S. Large-Cap Growth ETF ( SCHG ) combines the concentration of the Nasdaq ( NDX ) with the holdings of the S&P 500 ( SPX ). It tracks the Dow Jones U.S. Large-Cap Growth Total Stock Market Index, which includes over 200 stocks. These stocks are selected based on growth and valuation criteria from a universe of 750 names, and the index is rebalanced accordingly. Can the ETF continue to offer above-average returns while maintaining a lower risk profile?

Performance

The SCHG has beaten the S&P 500 since its inception but is substantially below the Nasdaq 100. This is primarily due to an underlying index construction that it tracks, which is large-cap-focused but not tech-focused.

Index Construction

The ETF tracks the Dow Jones U.S. Large-Cap Growth Total Stock Market Index, which separates stocks into growth or value using six criteria. This methodology screens over 750 large-cap stocks and selects the best growth portfolio of 250. What I particularly like about this method is that three of the criteria are forward-looking and use consensus forecasts. My main concern is whether Apple's ( AAPL ) estimated 6% EPS growth of YE24-25 and 28x PE ratio is sufficient to keep it in the index.

Holding Concentration

The ETF holds over 200 stocks, but 80% of assets are concentrated in only 40. I compared the holdings of SCHG with those of SPX and NDX. SCHG has similar names as the SPX but with a higher concentration for Apple, Microsoft ( MSFT ), and Alphabet ( GOOG ) compared to NDX.

Upside Potential

I used consensus price targets for the top 40 stocks, which constitute almost 80% of the assets under management ((AUM)), and found that the potential upside for the ETF by the end of 2024 is only 9%. This is quite disappointing, mainly because the upside of Apple and Microsoft, which together make up 26% of the portfolio, is mediocre. In order for this ETF to perform well, the market will have to be incorrect.

Looking Out Two Years

Given the low consensus upside for YE24, I calculated the YE25 price targets and upside potential for the 2-year period. I applied the PE target implied in the YE24 price target valuation on YE25 EPS estimates to derive the YE25 price targets. The portfolio saw a 14% increase in upside, which is a slight improvement. However, in my opinion, it is still being held back by the significant weightage given to Apple. According to consensus from 45 analysts compiled by Capital IQ, Apple is expected to show a price gain of only 10% for the YE24-25 period, whereas Microsoft has a potential gain of 30%. It was surprising to note that analysts predict over 50% upside targets for Amazon ( AMZN ), GE ( GE) , and T-Mobile ( TMUS ).

Testing for Growth & Valuation

Given the growth focus of the ETF, I calculated the EPS Growth using consensus estimates at 15% for the YE24-25 period a reasonably high number given these are large-cap stocks. As part of my analysis, I used the PEG (PE to Growth) method to compare the portfolio's growth with its valuation. A PEG ratio of 1 or less is considered to be cheap, but this portfolio is currently priced at 1.8x, which is relatively high in my view. To account for John Deere's high PEG of 66x, I adjusted the data accordingly. In the table below I ranked stocks from cheap to expensive. Progressive ( PGR ), Nvidia ( NVDA ), and Booking ( BKNG ) stood out for high and consistent EPS growth forecast with a 1x or less PEG.

Conclusion

I am giving a Hold rating to the ETF. It has a concentrated focus on large-cap growth, which has been successful in outperforming the S&P 500. However, considering the seemingly low growth, expensive valuation, and the high weight of Apple in the portfolio, it raises a question of whether this ETF can continue to outperform.

For further details see: