Nasdaq 100 Trust
is one of the most successful ETFs ever created, with assets under management exceeding $17 billion and boasting the highest average trading volume of any ETF listed in the U.S.
Despite being wildly popular, "the Qs," as they are often called, have also been one of the most disastrous investments of recent years, still trading well below their listing price in 1999.
To be sure, past is not prologue. The fund's precipitous drop in 2001-02 reflected the bursting of the tech bubble and has little to do with the future prospects of the current constituent companies, which is, after all, what the stock market is supposed to discount.
Could it be that the Qs, which have made a partial recovery from the depths of despair in 2002, are now cheap enough to make them a good investment?
Unfortunately, we don't think so. It is hard to justify the QQQQ as an investment because of its valuation. The trust is currently trading at a P/E of 26.7 times estimated 2006 earnings of $1.52, compared with a P/E of 15.3 times for the
S&P 500 SPDR
-- a 74% premium!
But the real kicker is that exposure to the technology, consumer discretionary and healthcare sectors, which account for 96% of assets in the QQQQ, can all be had for cheaper through purchase of the respective Select Sector Spyders.
Granted, the Sector SPDRs do not offer the exact same constituents in the exact same proportions -- by definition they do not exclude NYSE-listed stocks as does the Nasdaq 100 tracking stock; nonetheless, stocks within the same sector are likely to be highly correlated. Despite this, QQQQ trades at a steep premium to each Sector SPDR.
Examining the past can be helpful in one regard. We're not talking about past performance of stock prices; rather we're talking about the past profits of companies in the fund. Proponents of QQQQ will argue that the 100 companies which comprise the index offer fast earnings growth. That's true -- when profits are growing. But good times don't last forever, and when the punch bowl disappears, companies in QQQQ are likely to experience a much bigger decline in profits than a broader and more seasoned index like the
. Indeed, recent warnings from Nasdaq 100 constituents
may prove a harbinger.
Break Up the QQQQs
The chart below shows historical net margins for the S&P 500 and the Nasdaq 100. Times are good, and companies in the Nasdaq 100 index have collectively earned double-digit profit margins for the past two years and appear likely to do so again this year, a dramatic turnaround from the losses suffered in 2001-02. In comparison, companies in the S&P 500 have slightly lower margins now, but were able to maintain decent profits through the last recession.
We're not in the doom-and-gloom camp about the economy. But if the Nasdaq's profit margins are at or near a peak as they appear to be, then earnings growth will be limited to sales growth. In an economy that at some point will likely slow over the next few years -- and may already be slowing -- companies in QQQQ could suddenly find it very hard to deliver earnings growth that even keeps pace with, let alone exceeds, earnings growth in the S&P 500. That might prompt investors to question anew whether QQQQ is worth its 74% premium to the S&P 500, and, in turn, could have them heading for the exits like its 2001 all over again.
The Ups and Downs
Michael Krause is president and founder of AltaVista Independent Research. AltaVista provides fundamentally driven analysis of exchange-traded funds to help investors select ETFs based on investment merit, much the same way they would evaluate a single stock. The firm offers both print and online ETF research to subscribers, but does not manage clients' money. Mr. Krause is also a frequent contributor to broadcast and print media.