XLG - XLG: A Wonderful Buffett-Style ETF You've Never Heard Of

2023-11-23 07:20:00 ET

Summary

• The market of stocks always offers individual blue-chip bargains if you know where to look. However, individual companies always have the risk of failing.
• Exchange-traded funds are long-term "risk-free" portfolios that can't go to zero outside of an apocalypse, in which case money would be worthless anyway.
• They are great choices for building a core portfolio without the need for stock picking or constant rebalancing.
• Invesco S&P 500® Top 50 ETF is a 5-star rated, Buffett-style wide moat ETF consisting of the 50 largest U.S. companies, with AA-credit ratings, 30% free cash flow margins, and R&D budgets larger than the U.S. government's.
• Today, this ETF is trading at approximately historical fair value, an ultimate collection of "wonderful companies at fair prices," and Morningstar's analysts estimate it could deliver 12% long-term returns, similar to the Nasdaq, and almost 100% better inflation-adjusted long-term returns than the S&P 500 over time.

I love recommending individual stocks for one big reason. It's always and forever a market of stocks, not a stock market.

Here is just one example of how the red-hot market rally in 2023 is a red-hot Magnificent Seven rally.

The Magnificent Seven now makes up almost 30% of the U.S. stock market, which is 43% of the global stock market.

• 12% of the entire global stock market is now the magnificent 7.

Equally weighted, the stock market has a below-average year, and individual blue chips like Pfizer (PFE) can be found at the best valuations in 14 years. And that's far from the only example of incredible value.

• It's The Best Time In 23 Years To Buy 8% Yielding TC Energy
• Buy Like Buffett: British American's 9.3% Yield Is The Highest In 23 Years
• It's The Best Time In History To Buy 8% Yielding Verizon

And those are just the high-yield stocks! If you love growth, you can buy plenty of great opportunities today (AMZN, LOW, and GOOG are just three examples from my head).

Why I Love ETFs And So Should You

There is one downside to individual stocks—the fundamental risk of losing all your money or buying a value trap.

Over the last 40 years, almost 50% of U.S. stocks eventually fell 70% or more and never recovered.

According to S&P, the chance of Microsoft (MSFT) and Johnson & Johnson (JNJ), the only AAA-rated companies in America, going to zero in the next three decades isn't zero, it is 1 in 1,429.

This research note from BCA agrees with a more recent one from Goldman Sachs that the risk of nuclear war is 10% right now.

• Goldman warns in such an event the S&P is a complete loss.

The good news is that outside of this current proxy war with Russia, Goldman estimates the risk of nuclear war at 2.5%, the same as Home Depot (HD) or Costco (COST) going bankrupt in the next 30 years.

ETFs: Diversified "Risk-Free" Portfolios

Over the long term, the U.S. stock market is guaranteed to go up unless the world ends.

And for shorter time frames of around 10 years, a simple hedge fund like a 60/40 stock/bond portfolio is also risk-free - barring the apocalypse, in which case money won't matter.

• Both BCA and Goldman recommend ignoring such existential risks from the perspective of financial planning.

If you need money over the next 5 to 10 years, it's safe to invest it into a risk-managed hedge fund like the 60/40 or a ZEUS portfolio.

If you need money over 20+ years, the U.S. stock market is the best "risk-free" return because outside of an apocalypse, you'll earn positive inflation-adjusted returns superior to almost any other asset.

• the only way to lose money over 20+ years with U.S. stocks is to become a forced seller for emotional or financial reasons
• and that's why risk management is so important.

Exchange-traded funds, or ETFs, are a wonderful way for people without an interest in individual companies to own stocks, the best-performing asset class in history.

In fact, from 1821 to 2020, the inflation-adjusted returns of the U.S. stock market have been remarkably consistent for centuries at 7% (doubling your purchasing power every decade).

• $1 invested becomes $355,993 adjusted for inflation
• $1 became $415 in bonds adjusted for inflation
• $1 became $30.29 invested in cash.

This is why our Investing Group has an ETF tracker with our favorite ETFs for anyone who is looking for a strong core to any portfolio.

This week (Wednesday, actually), we're adding a new ETF to this tracker. And it's an ETF that I've been researching for several weeks per member request.

It's an ETF that is dead simple but also brilliant. It's an ETF so good that I'm even considering adding it to my family's $2.5 million family hedge fund .

Let me show you why the Invesco S&P 500® Top 50 ETF ( XLG ) is one of the best Warren Buffett-style ETFs you've never heard of but might want to consider putting on your watchlist...or even buying today.

Buffett's Logic Of Concentrated Diversification

Warren Buffett's portfolio at Berkshire Hathaway (BRK.A) has over 60 companies in it, but 40% is Apple (AAPL).

He's not afraid to concentrate on the highest quality and most dominant companies.

• Buffett invested 20% of BRK's capital into AMEX during the Salad Oil scandal crash
• AMEX went onto 50% annual returns for the next 4 years.

Small caps are a proven alpha factor, so wouldn't large caps be the opposite? An anti-beta factor?

Since the S&P is market cap weighted, large-cap investing in large companies by definition, should get you market-level returns.

• FactSet consensus is 1.6% yield + 8.5% growth = 10.1% long-term S&P returns (about 7.7% inflation-adjusted returns).

So, what is XLG? Simply, it is the 50 largest S&P companies, weighted by market cap and rebalanced annually.

Morningstar is confident that XLG will outperform its peers (large-cap ETFs) over time for one major reason, the benefits of concentration.

Consider the largest holdings in various diversified ETFs.

Vanguard Total World Stock Market ETF

Almost 10,000 stocks worldwide Vanguard can put into a total world ETF (actually 58,200 public companies in the world) and the top 10 are 16% of the portfolio.

Vanguard Total Stock Market ETF (Wilshire 5000)

Vanguard Russell 1000 ETF

Vanguard S&P 500 ETF

Schwab Growth ETF (250 fastest growing S&P 500)

Nasdaq 100

S&P 50 ((XLG))

Diversification Is Important Up To A Point

You might think owning 500 stocks is better than 50, and 5000 is even better.

• 5 Facts Investors Need To Know About Diversification

Reducing volatility risk is a game of rapidly diminishing returns.

While volatility isn't actual risk, you can see that the 500th stock in the S&P 500, the 1000th in the Russell 1000, and the 10,000th in the Vanguard World Index are irrelevant.

The Benefits Of Mega-Cap Companies

The magnificent seven is growing faster than corporate America in general.

Is this permanent? Maybe, maybe not. Microsoft, Amazon (AMZN), and Alphabet/Google (GOOG), in cloud computing, appear to have created an impenetrable moat for now (as one example).

GOOG's market share in search is 92% and has been stable at over 90% for a decade. Everyone uses GOOG because it has the best results. And it has the best results because everyone uses it.

YouTube is #1 in social media content viewing and has over 100 million channels.

A channel for anything you might be looking for is why everyone watches YouTube and that's why it's where all the content creators go.

The margins are twice as high at the magnificent seven and are expected to stay that way for the foreseeable future.

Let's consider Amazon. They spent 20 years building out one of history's most impressive delivery and logistics networks.

In the Pandemic, they doubled that capacity in 2 years.

What other company on earth could do that? None.

Now, they have a logistics and delivery network that rivals UPS and FedEx.

Who can compete with Amazon? Walmart? (WMT) OK, and what small company is going to unseat Amazon?

The biggest threat to the Magnificent 7 appears not to be competition from smaller companies but government regulation and being broken up for being too big.

But as far as consumer preferences go, it seems that these companies have the loyalty of billions.

• Morningstar analysts estimate the Magnificent 7 long-term growth rate at 15%.

Soaring interest costs badly hurt small companies, while big companies are flush with cash.

In 2022, the Magnificent 7 spent $145 billion on R&D, which is even higher this year.

• In 2022 the U.S. government spent $170 billion on R&D.

Within a few years, the magnificent seven will spend more on R&D than the U.S. government.

Total Return Potential: The Benefit Of XLG Over The S&P

Owning the Nasdaq 100 is a popular growth strategy. However, you are 70% tech and don't own great companies in the NYSE like LOW, MA, or UNH.

XLG Sectors: Approximately 60% Tech

Factoring in that AMZN and Tesla (TSLA) are consumer discretionary, and GOOG, META, and NFLX are communication, we can see that around 60% or so of XLG is big tech.

That's slightly more diversified than the Nasdaq 100 (NDX) but still benefits from the incredible growth of the Mag 7 (15% according to Morningstar).

• 15% growth = double every five years.

FactSet estimates that the S&P 500 (SP500) will remain dominated by big-cap tech, boosting long-term EPS growth from 6% to 8.5%.

What about XLG?

How does dropping the 450 smallest companies in the S&P 500 affect growth?

Morningstar Analysts Estimate 11% Long-Term Earnings Growth

Morningstar analysts believe XLG will deliver about 12% long-term returns.

• Vs 10% S&P and 12.5% Nasdaq.

What About The Crazy Valuations?!

XLG is trading at 20X earnings, which isn't that absurd.

• KO and PEP historically trade at 20X
• so do the dividend aristocrats
• so does the Nasdaq (over 20 years)
• GOOG, AAPL, AMZN, all average 25X earnings/cash flow, and MSFT 27.

Historical Fair Value

(Source: FactSet.)

In fact, the long-term median P/E for XLG is 20, indicating that the FactSet estimated P/E of 21.6 is roughly in line with fair value.

Historical Fair Value- Cash Adjusted P/E

Don't forget that the largest 50 companies in America have the largest cash piles in history.

Enterprise value is market cap + debt - cash and represents the actual acquisition value of the company.

• For example, a $100 billion market cap company with no debt and $50 billion in cash is a $50 billion enterprise value.

Imagine that the cash flow ((EBITDA)) of a $100 billion company is $5 billion.

That's 20X EBITDA for a valuation, and you might think that's too high.

But if that company has $50 billion in cash, then it's a 10X EV/EBITDA multiple and a good value.

• EV/EBITDA is the #1 metric used by private equity for this reason
• 11X to 12X EV/EBITDA is what private equity deals are closing at in 2023.

(Source: FactSet.)

XLG is trading at a modest historical premium, though 15X forward cash-adjusted earnings for 11% growth in the widest moat companies on earth isn't dangerous levels of overvaluation.

29% free cash flow margins and 25% returns on invested capital are sensational profitability.

From the widest moat and financially most bullet-proof companies on earth.

MSFT is AAA-rated, and GOOG, AMZN, and AAPL are all AA-rated companies.

You're not just talking about A-rated companies; the average credit rating for XLG is AA-rated.

• Average 30-year bankruptcy risk is about 0.51%.

Risk Profile: Why XLG Isn't Right For Everyone

Anyone buying XLG over something like the S&P 500 or Nasdaq 100 is making a very specific bet.

• the 50 largest U.S. companies are always going to remain a great investment.

The expense ratio of 0.2% is 0.17% higher than low-cost S&P ETFs from Vanguard and Schwab.

For the last 15 years, XLG has been in the top 12% of large-cap funds and the top 7% when adjusted for taxes, an impressive 12.5% annual return.

That's similar to what Morningstar's analysts expect in the future.

However, the major downside of XLG is that if big-cap tech doesn't dominate the future of the US economy, you might not beat the S&P enough to justify that 0.17% higher expense ratio.

Historical Returns Since 2005

Since 2005 when XLG started, it's beaten the S&P by 0.21% or 0.04% more than its added expense ratio.

The longer you own XLG, the bigger the performance difference in average rolling returns.

However, the difference between the S&P and XLG will not be life-changing.

• XLG has delivered 4% better returns than the S&P over 18 years.

Another thing to consider is that XLG yields 1%, similar to the Nasdaq and paltry by even S&P standards.

And the dividend income isn't as consistent as the S&P and historically has only grown at 6.5% per year.

• 2% slower than earnings growth
• because big cap tech isn't dividend-growth focused, even the dividend payers like MSFT and AAPL.

Bottom Line: XLG Is A Great Buffett-Style ETF Worth Considering Adding To Your Portfolio

If you want to own the dream team of global capitalism, then XLG is a potentially wonderful ETF for you to consider.

The 50 largest U.S. companies are like the all-star team in the Olympics. The best of the best, the elite of the elite, the most valuable and innovative companies in history.

As long as you understand the pros and cons of concentrated diversification, there are a lot of potential benefits to owning some XLG.

• potentially 2% higher long-term returns vs S&P 500
• over 30 years, 81% higher potential inflation-adjusted returns
• the most profitable companies (almost 30% free cash flow margins!)
• the strongest balance sheet (average AA-credit rating).

Currently, XLG is trading at 20X forward earnings and 14X cash-adjusted earnings, a tad above its historical fair value (3% to 7%) but close enough to Buffett's "Wonderful companies at fair prices" to recommend today.

For further details see:

XLG: A Wonderful Buffett-Style ETF You've Never Heard Of