Our research on holdings enables investors to find funds with high quality holdings – AND – low fees.

Investors are good at picking cheap funds. We want them to be better at picking funds with good stocks. Both are required to maximize success.

Figure 1 shows that 60% of fund assets are in ETFs and mutual funds with low costs but only 5% of assets are in ETFs and mutual funds with Attractive holdings. This discrepancy is astounding.

Source: New Constructs, LLC and company filings

These issues are related, in my opinion. If investors had more insight into the quality of funds’ holdings, I think they would allocate a lot less money to funds with poor quality holdings.

Investors deserve research on the quality of stocks held by ETFs and mutual funds.

Quality of holdings is the single most important factor in determining an ETF or mutual fund’s future performance. No matter how low the costs, if the ETF or mutual fund holds bad stocks, performance will be poor. Costs are easy to find but research on the quality of holdings is almost non-existent.

Figure 2 shows investors are not putting enough money into ETFs and mutual funds with high-quality holdings. Only 393 of 7182 (5% of assets) of ETFs and mutual funds allocate a significant amount of value to quality holdings. 95% of assets are in funds that do not justify their costs and over charge investors for poor portfolio management.

Source: New Constructs, LLC and company filings

Figure 3 shows that investors successfully identify low-cost funds. 60% of assets are held in ETFs and mutual funds that have Attractive-or-better rated Total Annual Costs, my apples-to-apples measure of the all-in cost of investing in any given fund.

Out of the 7187 ETFs and mutual funds I cover, 1,302 earn an Attractive-or-better Total Annual Costs rating.

Clearly, ETF and mutual funds investors are smart shoppers when it comes to finding cheap investments. But cheap is not necessarily good.

PRIMECAP Odyssey Funds: PRIMECAP Odyssey Aggressive Growth Fund (POAGX) is a great example of a fund with low costs but poor holdings. Its total annual costs are Attractive at only 0.88%. However, it still gets an overall predictive rating of Very Dangerous because no matter how low its fees, I expect it to underperform because it allocates over 53% of its assets to Dangerous-or-worse rated stocks. It also holds over 8% of its assets in cash. Investors should not be paying fees, no matter how low, for a fund to simply hold their cash for them. Low fees cannot boost fund performance. Only good stocks can boost performance.

Boulder Brands (BDBD) is one of my least favorite stocks held by POAGX and gets my Dangerous rating. Its economic earnings are negative and declining, driven by its low return on invested capital (ROIC), which declined from 3% to 2.5% in 2012. Along with its low ROIC, BDBD’s $133 million in asset write-downs (over 23% of net assets) is a sign of management failure to identify good investments. Add in BDBD’s significant debt, employee stock option liability, and deferred tax liability ($307 million combined, 53% of net assets) and BDBD’s financial situation starts to look rather shaky.

Instead of reflecting these poor fundamentals, however, BDBD stock is priced for significant growth. To justify its current valuation of ~$9.61/share, BDBD would need to grow after-tax profit (NOPAT) by 18% compounded annually for 16 years. BDBD’s valuation is telling a very different story than its income statement and balance sheet.

Heavy allocation to BDBD helps to explain why POAGX earns its Very Dangerous rating despite having such low costs.

Source: New Constructs, LLC and company filings

Investors should allocate their capital to funds with both high-quality holdings and low costs because those are the funds that offer investors the best performance potential.

But they do not. Not even close.

Figure 4 shows that 3% of ETF and mutual fund assets are allocated to funds with low costs and high-quality holdings according to my Predictive Fund Ratings, which are based on the quality of holdings and the all-in costs to investors.

Note the fund industry offers 3,206 Dangerous-or-worse ETFs and mutual funds compared to just 158 Attractive-or-better ETFs and mutual funds, over 20 times more bad funds than good funds. That means a lot of fees are being paid to managers that do not deserve them.

Source: New Constructs, LLC, and company filings

Investors deserve forward-looking ETF and mutual fund research that assesses both costs and quality of holdings. For example, Vanguard Consumer Staples ETF (VDC) has Attractive total annual costs of only 0.15% and allocates over 60% of its assets to Attractive-or-better rated stocks. This fund is proof that investors can have their cake and eat it too.

The Proctor & Gamble Company (PG) is one of my favorite stocks held by VDC and earns my Attractive rating. PG has an impressive track record of consistency, growing its after-tax profit (NOPAT) by 9% compounded annually over the past 14 years. Normally, I warn investors about companies whose reported earnings are rising while economic earnings decline, but in PG’s case the reverse is true. Over $1.2 billion in non-operating items hidden in the operating expenses caused PG’s GAAP net income to decline by over $1 billion while its NOPAT and economic earnings actually increased slightly.

PG’s misleadingly low reported income contributes to it being valued fairly cheaply by the market. At its current valuation of ~$78.59/share, PG has a price to economic book value ratio of only 1.1. This low valuation implies that the market expects PG’s NOPAT to grow from its current level by no more than 10% for the remainder of its corporate life. Given that PG has averaged annual NOPAT growth of almost 10% for 14 years, investors should feel confident that PG can exceed the modest expectations the market has set for it.

VDC’s 11% allocation to PG helps to drive its Attractive rating.

Anyone can look at the stocks held by funds, so why are most popular fund rating systems based on backward-looking past performance?

I do not know, but I do know that the lack of transparency into the quality of portfolio management provides cover for the ETF and mutual fund industry to continue to over charge investors for poor portfolio management. How else could they get away with selling nearly 20 times more Dangerous-or-worse ETFs and mutual funds than Attractive-or-better?

John Bogle is correct – investors should not pay high fees for active portfolio management. His index funds have provided investors with many low-cost alternatives to actively managed funds.

However, by focusing entirely on costs, he overlooks the primary driver of fund performance: the stocks held by funds.

Research on the quality of portfolio management of funds empower empowers investors to make better investment decisions. Investors should no longer pay for poor portfolio management. 

Sam McBride contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector or theme.

We begin the 1Q13 Style series with our Style Rankings report, which details the best styles for finding quality ETFs and mutual funds. Next we highlight the best & worst for each style in the Rating Breakdown By Style report. We follow with detailed reviews of the Best & Worst for each style (links below).

Style Series: Best & Worst ETFs and mutual funds for:

1. Large Cap Blend
2. Large Cap Value
3. All Cap Blend
4. Large Cap Growth
5. All Cap Growth
6. All Cap Value
7. Mid Cap Blend
8. Mid Cap Growth
9. Mid Cap Value
10. Small Cap Growth
11. Small Cap Blend
12. Small Cap Value

My analysis of the Financial Footnotes to CSCO’s Form 10-K for 2012 revealed that CSCO’s GAAP net income actually understated its profitability and growth. A variety of unusual expenses hidden in operating items totaling $530 million dollars (over 5% of net income after tax) caused CSCO’s GAAP net income to be $8 billion while its true net operating profit after tax (NOPAT) was over $8.5 billion. In addition, CSCO’s true economic earnings per share grew by 58% in 2012, more than double the 28% growth in its reported earnings per share.

In addition, CSCO has several signs of high-quality management: a top quintile return on invested capital (ROIC) of 18%, few asset write-downs (less than 10% of net assets), and a compound annual growth rate for NOPAT of 26% over the past 10 years.

The good news for investors is that CSCO, even after today’s surge, is still cheap. At yesterday’s closing value of ~$21.21/share, it had a price to economic book value ratio (P/EBV) of 0.7, implying a permanent 30% decrease in NOPAT. At its current value of ~23.97, CSCO’s (P/EBV) has only gone up to 0.8.

CSCO stock is still very cheap, and everything that made me recommend it to investors still applies. I’ve said before that quarterly earnings can be misleading. Investors focused on the reported earnings could never see this surprise coming as we did. The stock’s super-cheap valuation suggests that too many analysts do not understand the true earnings of this business and underrate this company’s profitability. Astute investors should pounce on this opportunity.

New Constructs’ database of accounting distortions in over 50,000 annual reports across over 3000 stocks provides investors with unrivalled research. We do the diligence on the “big data” in the voluminous disclosures in annual reports so our clients can meet their fiduciary responsibilities with confidence.

First Trust NASDAQ Technology Dividend Index Fund (TDIV) gets my Attractive rating and allocates over 7.5% of its assets to CSCO.

Sam McBride contributed to this article

Disclosure: David Trainer owns CSCO. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

Profiting From Disruptive Innovation

My favorite aspect of Accenture plc’s (ACN) business model is it profits from others’ innovations without having to incur the costs and pressures of innovation, itself. By establishing itself as the go-to name in IT and management consulting, Accenture has the potential to bring in new business with every major disruptive innovation, regardless of where that innovation comes from.

In The Innovators Dilemma, Clayton Christensen explains how companies that do everything right can still struggle when disruptive innovation changes the market. The leaders at Accenture have clearly read this book, as the company excels at identifying new, high growth markets brought about by disruptive innovations.

For example, Accenture developed cloud solutions for its customers. Its Cloud Platform and more than 6,700 cloud experts brought in $1 billion in revenue last year, a promising sign for an industry as a whole has been growing by more than 27% compounded annually.

In addition, Accenture’s holistic view towards serving its clients has allowed it to achieve an impressive diversity in its business. Recently it has significantly grown its digital marketing division, landing contracts from BMW earlier this month. Like cloud computing, digital marketing is a rapidly growing business, with industry revenues growing by 15% in 2012. Not many companies can offer highly technical cloud support and a creative advertising campaign at the same time. Accenture’s diverse capabilities differentiate it from its competitors.

Sources: New Constructs, LLC and company filings

Accenture faces plenty of competition from companies like IBM and its Global Business Services unit, but the quality of Accenture’s people enables it to remain the leader in consulting. This strategy is self-perpetuating. Accenture is like a college football dynasty: the best high school recruits want to play for the best college programs, and the best young consultants want to work at the best consulting firm, Accenture.

Consistent Track Record of Profitability

The quality of Accenture’s strategy manifests in its profitability. ROIC is a key indicator of management’s ability to create value for shareholders, and Accenture has had a high and growing ROIC for the past decade. Figure 1 shows Accenture’s ROIC versus its weighted average cost of capital (WACC) over the past 10 years.

The 30% ROIC that Accenture had 10 years ago is exceptional. The fact that it has more than doubled its ROIC since then is a testament to its high quality management. Few firms can sustain those kinds of returns, but I think Accenture has the ability to do so. In 2012, its asset write-downs totaled only 3.5% of its total net assets, a sign that the company wastes very little of its invested capital. As long as management continues to allocate capital efficiently, Accenture’s advantages in quality and diversity of services should allow it to maintain its high returns.

More recent data also reflects brightly for the outlook on Accenture. Accenture grew its net operating profit after tax (NOPAT) by 18% in 2011 and 12% last year. Its IT consulting division significantly outperformed IBM’s last year, as revenue for IBM Global Business Services declined by 2% in 2012.

No matter what time range I review, Accenture’s history attests to the quality of its management and business model.

Priced for Stagnation

Despite its impressive fundamentals and strong track record of growth, ACN is priced like a company with almost no growth potential. At its current valuation of ~$80.76, ACN has a price to economic book value ratio of 1.11, implying that it will never grow NOPAT by more than 11% from its current level for the remainder of its corporate life. Contrast this modest expectation with ACN’s NOPAT compound annual growth rate of 12.6% over the last 10 years.

There does not appear to be any reason to expect ACN’s growth to slow down so drastically. If anything, the increasingly high-tech economy and the growth of “big data” should increase the demand for ACN’s services. On the balance sheet, ACN’s $5.2 billion in excess cash more than covers its liabilities, meaning investors don’t have to worry about future cash flows being significantly diverted to pay off debts or underfunded pension plans.

It’s rare to find a global leader in a growing and stable business with almost no growth built into the stock price. Investors should take advantage of the chance to buy such a solid company at a cheap price.

For investors who prefer their exposure to ACN to come through a mutual fund or ETF, I recommend Advisers Investment Trust: Independent Franchise Partners US Equity Fund (IFPUX) due to its 5.3% allocation to ACN and Attractive rating.

Sam McBride contributed to this report.

Disclosure: David Trainer owns ACN. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the style. Not all Small-cap Value style ETFs and mutual funds are created the same. The number of holdings varies widely (from 15 to 1,639), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Small-cap Value style, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings.

My fund rating methodology is detailed here.

Investors should not buy any Small-cap Value ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this style, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this style on my free mutual fund and ETF screener.

iShares Enhanced U.S. Small-Cap ETF (IESM), First Trust Small Cap Value AlphaDEX Fund (FYT) and Vanguard S&P Small-Cap 600 Value ETF (VIOV) are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

10 mutual funds are excluded from Figure 2 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

WisdomTree SmallCap Earnings Fund (EES) is my top-rated Small-cap Value ETF and Westcore Small-Cap Value Dividend Fund (WISVX) is my top-rated Small-cap Value mutual fund. EES earns my Dangerous rating and WISVX earns my Neutral rating. For those investors turned off by WISVX’s $500,000 initial minimum, WTSVX offers the same holdings for only slightly higher costs.

ProShares Ultra Russell2000 Value (UVT) is my worst-rated Small-cap Value ETF and American Century Capital Portfolios, Inc: Small Cap Value Fund (ACSCX) is my worst-rated Small-cap Value mutual fund. UVT earns my Dangerous rating and ACSCX earns my Neutral rating.

It is astonishing to me that no Small-cap Value ETFs or mutual funds earn an Attractive rating, as 331 out of 2,168 stocks (19% of the market value) in the style earn an Attractive-or-better rating. There are more than enough quality stocks out there for Small-cap Value ETFs and mutual funds to put together high quality portfolios.

The takeaway is: mutual fund managers allocate too much capital to low-quality stocks and Small-cap Value ETFs hold poor quality stocks.

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors should stay away from Small-cap Value ETFs and mutual funds, as 13 out of 14 Small-cap Value ETFs (almost 100% of total net assets) and 265 Small-cap Value mutual funds (99% of total net assets) earn a Dangerous-or-worse rating. Investors should focus on one of the many Attractive and Very Attractive rated stocks in this style.

World Acceptance Corp (WRLD) is one of my favorite stocks held by Small-cap Value ETFs and mutual funds and earns my Very Attractive rating. For such a small company, WRLD’s track record of profit growth is very impressive. Over the past 14 years WRLD has grown after tax profit (NOPAT) by 20% compounded annually. WRLD has not posted a year of declining NOPAT since the 1990’s. Last year it grew NOPAT by 12% while actually decreasing its invested capital by 3%, helping it to achieve a top quintile return on invested capital (ROIC) of 22%. WRLD’s small, consumer finance loans make it a lot less likely to blow up than bigger financial companies that take many more risks.

However, the market appears to be ignoring WRLD’s strong fundamentals. At its current valuation of~$90.15/share, WRLD has a price to economic book value ratio of 0.9, implying a permanent 10% decline in NOPAT. Why the market price is projecting a decline for WRLD when it has grown every year for more than a decade is beyond me, but it is great news for investors. Strong fundamentals combined with a cheap valuation make WRLD a great choice for those seeking exposure to the Small-cap Value style.

Popular Inc. (BPOP) is one of my least favorite stocks held by Small-cap Value ETFs and mutual funds and earns my Very Dangerous rating. BPOP growth in GAAP net income last year is misleading. Adjusting for factors like declining reserves and non-operating tax adjustments, BPOP’s true NOPAT actually declined by nearly 40% last year. Investors should not be fooled by BPOP’s misleading accounting: its 2% ROIC and 13 years of negative economic earnings out of the past 14 reveal it to be a poorly managed company. The market appears to be falling for BPOP’s rising GAAP net income, as significant profit growth is built into its valuation. To justify its current share price of ~$28.75. BPOP must grow NOPAT by 10% compounded annually for 18 years. Despite the potential for growth in the Latin American financial market, it’s hard to justify that level of optimism for a company with as poor a track record as BPOP.

Figures 4 and 5 show the rating landscape of all Small-cap Value ETFs and mutual funds.

My Style Rankings for ETFs and Mutual Funds report ranks all styles and highlights those that offer the best investments.

Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 14 ETFs and 276 mutual funds in the Small-cap Value style.

Sam McBride contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style or theme.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the style. Not all Small-cap Blend style ETFs and mutual funds are created the same. The number of holdings varies widely (from 12 to 2,288), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Small-cap Blend style, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings.

My fund rating methodology is detailed here.

Investors should not buy any Small-cap Blend ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this style, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this style on my free mutual fund and ETF screener.

* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

PowerShares RAFI Fundamental Pure Small Core Portfolio (PXSC), Vanguard S&P 600 Small Cap ETF (SLY) and ProShares Ultra SmallCap 600 (SAA) are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Six mutual funds are excluded from Figure 2 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

iShares Core S&P Small-Cap ETF (IJR) is my top-rated Small-cap Blend ETF and Virtus Quality Small-cap Fund (PXQSX) is my top-rated Small-cap Blend mutual fund. IJR earns my Dangerous rating and PXQSX earns my Neutral rating

iShares Russell Microcap Index Fund (IWC) is my worst-rated Small-cap Blend ETF and Pacific Advisors Fund Inc: Small Cap Value Fund (PASMX) is my worst-rated Small-cap Blend mutual fund. IWC earns my Dangerous rating and PASMX earns my Very Dangerous rating.

Figure 3 shows that 421 out of the 2,590 stocks (over 16% of the market value) in Small-cap Blend ETFs and mutual funds get an Attractive-or-better rating. However, no ETFs or mutual funds in the Small-cap Blend style earn an Attractive rating.

I am astonished that with so many good stocks to choose from ETF providers and mutual fund managers are not putting together more attractive portfolios for investors.

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Small-cap Blend ETFs and mutual funds, as all 22 ETFs and 556 out of 643 Small-cap Blend mutual funds earn a Dangerous-or-worse rating. There are no Attractive ETFs or mutual funds in the style, so investors should focus on individual stocks instead.

Teradyne Inc. (TER) is one of my favorite stocks held by Small-cap Blend ETFs and mutual funds and earns my Very Attractive rating. TER’s 15% return on invested capital (ROIC) is in the top quintile of all 3000 companies I cover. TER is ideally situated to take advantage of the rapid pace of innovation in our economy. As a developer of automatic test equipment with customers like Samsung, IBM (add tickers, pls), and Texas Instruments, TER is in the enviable position of being able to profit off of innovation without having the pressure to innovate itself. TER’s $400 million free cash flow last year and $1 billion in excess cash give it the resources to fuel future growth.

Despite these strong fundamentals, TER is priced for permanent profit decline. At its current valuation of ~$16.15, TER has a price to economic book value ratio of 0.9, implying a permanent 10% decline in after tax profit (NOPAT). With such high ROICs, a healthy balance sheet, and an appealing position in the market, I think Teradyne will exceed the pessimistic expectations baked into its stock’s valuation.

Sanmina Corp (SANM) is one of my least favorite stocks held by Small-cap Blend ETFs and mutual funds and earns my Very Dangerous rating. SANM last earned positive economic earnings in 1998. Its NOPAT declined by 35% between 2010 and 2012. The main source of SANM’s struggles is poor capital allocation. SANM has over $4.2 billion in accumulated asset write-downs, 200% or twice its reported net assets. Asset write-downs are a sign of management failure. When the amount of value that management has destroyed is so high, something is seriously wrong.

The market appears to be ignoring the very shaky fundamentals of SANM and is projecting considerable growth for the company. To justify its current valuation of ~$12.44/share, SANM would need to grow NOPAT by 10% compounded annually for six years. For a company with declining NOPAT, no recent track record of economic profitability, and an ROIC under 2%, betting on that level of growth is too risky.

Figures 4 and 5 show the rating landscape of all Small-cap Blend ETFs and mutual funds.

My Style Rankings for ETFs and Mutual Funds report ranks all styles and highlights those that offer the best investments.

Review my full list of ratings and rankings along with reports on all 22 ETFs and 643 mutual funds in the Small-cap Blend style.

Sam McBride contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style or theme.

Figure 1 ranks from best to worst the seven small-cap growth ETFs that meet our liquidity standards and Figure 2 shows the five best and worst-rated small-cap growth mutual funds. Not all Small-cap Growth style ETFs and mutual funds are created the same. The number of holdings varies widely (from 27 to 1,344), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Small-cap Growth style, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Small-cap Growth ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this style, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this style on my free mutual fund and ETF screener.

* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Vanguard S&P Small-Cap 600 Growth ETF (VIOG), Guggenheim S&P Smallcap 600 Pure Growth (RZG) and PowerShares RAFI Fundamental Pure Small Growth Portfolio (PXSG) are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Vanguard S&P Small-Cap 600 Growth ETF (VIOG) is my top-rated Small-cap Growth ETF and Virtus Small-cap Core Fund (PKSFX) is my top-rated Small-cap Growth mutual fund. VIOG earns my Dangerous rating and PKSFX earns my Neutral rating.

Vanguard Small-Cap Growth ETF (VBK) is my worst-rated Small-cap Growth ETF and Forum Funds: Adams Harkness Small Cap Growth Fund (ASCGX) is my worst-rated Small-cap Growth mutual fund. VBK earns my Dangerous rating and ASCGX earns my Very Dangerous rating.

I am astonished that no ETFs or mutual funds in the Small-cap Growth style earn an Attractive rating, as 290 stocks (over 15% of the market value) in Small-cap Growth funds are rated Attractive-or-better. Figure 3 shows details on how investors allocate capital to stocks, ETFs and mutual funds in this style.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Small-cap Growth ETFs hold poor quality stocks.

Sources: New Constructs, LLC and company filings

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors should avoid Small-cap Growth ETFs and mutual funds, as 10 out of 10 ETFs and 410 out of 432 mutual funds (85% of total net assets) in the Small-cap Value style earn a Dangerous-or-worse rating. No Small-cap Growth ETFs or mutual funds earn an Attractive-or-better rating. Investors should focus on individual stocks instead.

Plantronics (PLT) is one of my favorite stocks held by Small-cap Growth ETFs and mutual funds and earns my Very Attractive rating. PLT has grown its after tax profit (NOPAT) by 24% compounded annually over the past decade, and it has a top-quintile return on invested capital (ROIC) of 29%. Those two numbers tell quite a story by themselves; you won’t get that kind of economic profitability from many other small-caps. One would expect a company with such impressive fundamentals to command a lofty valuation, but the market has very conservative expectations for PLT. At its current valuation of ~$43.55/share, PLT has a price to economic book value ratio of only 1.1. Such a low valuation implies that PLT will grow NOPAT no more than 10% from its current level for the remainder of its corporate life. Modest growth expectations combined with a strong track record of growth makes PLT a great stock for investors seeking exposure to the Small-cap Growth style.

InnerWorkings Inc. (INWK) is one of my least favorite stocks held by Small-cap Growth ETFs and mutual funds and earns my Very Dangerous rating. INWK’s reported earnings are positive and increasing while its economic earnings are negative and declining ($0.37/share versus -$0.22/share). Economic earnings are a much more accurate representation of the true profitability of the company. However, investors are clearly focusing on the reported EPS, as INWK is currently priced for surprisingly high growth. To justify its valuation of ~$9.92/share, INWK needs to grow NOPAT by 20% for 11 years. Given that INWK acts essentially as a middleman, connecting clients to printing suppliers, it’s hard to picture a scenario where it manages such drastic growth. Investors can find other companies with better growth potential and stocks with more reasonable valuations.

Figures 4 and 5 show the rating landscape of all Small-cap Growth ETFs and mutual funds.

My Style Rankings for ETFs and Mutual Funds report ranks all styles and highlights those that offer the best investments.

Review my full list of ratings and rankings along with reports on all 10 ETFs and 432 mutual funds in the Small-cap Growth style.

Sam McBride contributed to this report.

Disclosure: David Trainer owns PLT. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style or theme.

We discuss my reasoning and the bet that holders of AAPL are making by holding the stock at current levels.

David Faber grills me on my calculations.

My original article on Apple can be seen here.

Apple Inc. (AAPL) is in the Danger Zone. Too many investors see AAPL through the rear view mirror and assume that its sky-high profits and return on invested capital (ROIC) are sustainable. As I detail in my CNBC interview, Apple is not cheap and investors should not underestimate the impact of losing Steve Jobs. Without another ground-breaking innovation like the iPhone, Apple is destined to be just another consumer electronics company. And the stock is very expensive relative to other technology and consumer electronics stocks.

Just Another Computer Company

Almost a year ago, I wrote a bullish article on Apple, arguing that its sky-high ROIC made it a great value for investors even at such a high price. Since then, the company’s ROIC fell from 340% to 271%. Add the lack of innovation and issues with new products, and I see the recent drop in ROIC as a new trend. Without significant product differentiation, Apple cannot maintain the ultra high profit margins and ROICs.

Comparing Apple’s ROIC to its competitors and industry averages provides fair benchmarks for what might be a more reasonable future level of ROIC for AAPL.

Figure 1 compares Apple’s ROIC to competitors Microsoft (MSFT), Google (GOOG), Blackberry (BBRY) and Dell (DELL) as well as the market-weighted average ROICs of different industry segments. This figure shows just how far Apple’s ROIC could fall if it returns to more normal levels, which I think is inevitable after the departure of Steve Jobs. The problem is that AAPL is priced to maintain a sky-high ROIC of 124%.

No Longer a “Value” Stock

People think AAPL is a value stock, but that’s only the case if one assumes its current ROIC is sustainable. AAPL’s current valuation of ~$452.97/share implies a long-term ROIC of 124%. I think that level of profitability is still too high to maintain.

If we assume Apple can maintain an ROIC close to Microsoft’s, around 75%, then the stock is only worth ~$295. If Google’s 34% ROIC is the benchmark, the stock is worth only ~$191. If we assume Apple can maintain a long-term ROIC of 20%, which is still high in the consumer electronics sector, the stock is worth ~$162.

The “value” in Apple is an illusion. Astute investors need to look at Apple through the lens of what is a reasonable ROIC in the future.

The Law of Competition Reverts ROICs To The Mean

Super high ROICs are a blessing and a curse. On the one hand, a 340% ROIC is an unprecedented achievement for a company Apple’s size. On the other hand, it invites lots of competition from businesses seeking to get in on those high margins.

For years, Apple’s superior products could demand premium pricing. Today, other phone and tablet makers are quickly narrowing the gap between their products and Apple’s. The differences between an iPhone and a Samsung Galaxy or a Motorola Droid are no longer enough to justify a major difference in price.

The loss of Steve Jobs hits Apple extremely hard when it comes to innovation and product quality. His energy, creativity, and attention to detail played a critical role in enabling Apple to stay ahead of the pack for as long as it did. Without him, Apple has not come up with any significant new innovations and appears to be falling a bit behind the competition. The Apple Maps fiasco last year revealed how much the company missed his attention to detail.

Taking the competition to court does not stop them. It only slows them down – at best. Apple’s $1 billion verdict in its patent infringement lawsuit against Samsung last year was encouraging, but that amount was reduced 50% on appeal. Patent suits are very expensive (time and money) and difficult to prosecute. As hard as it tries, Apple will not be able to sue its competitors out of business. Google, Samsung, Blackberry, Microsoft and many other firms will continue to put out phones, computers, and tablets that will be increasingly competitive with or better than Apple products. Apple needs another ground-breaking new product to maintain margins and profit growth.

Do not get me wrong. Apple is still a great company and an American icon that gave us amazing new devices. My point is that a great company does not make a great stock. And AAPL is not a good stock.

Beware of Groupthink

Normally I end these articles by warning investors to avoid the ETFs and mutual funds that allocate significantly to the stock in the Danger Zone. With AAPL, there are too many funds to include in this report.

An astounding 664 of the 7,000 ETFs and mutual funds I cover allocate at least 5% of their value to AAPL. Mutual fund managers have caught a serious case of groupthink when it comes to AAPL. No fund manager or ETF provider wants to have to explain to investors why they did not own AAPL if the stock takes off again. So, they keep the allocation rather than do more independent research.

Mutual fund managers and ETF providers are too often focused on performing in line with their peers. That strategy helps protect them from losing market share. In the event of a market downturn or a big drop in a widely-held stock, they are protected from losing assets as long as all or a majority of other funds underperform along with them. The goal is to avoid being singled out and risk losing more assets than peers.

Sam McBride contributed to this article

Disclosure: David Trainer owns MSFT. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the style. Not all Mid-cap Value style ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 2880), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Mid-cap Value style, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings.

My fund rating methodology is detailed here.

Investors should not buy any Mid-cap Value ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this style, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this style on my free mutual fund and ETF screener.

* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Vanguard S&P Mid-Cap 400 Value ETF (IVOV) and SPDR S&P 400 Mid Cap Value ETF (MDYV) are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Seven funds are excluded from Figure 2 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

iShares Morningstar Mid Value Index Fund (JKI) is my top-rated Mid-cap Value ETF and Victory Portfolios: Established Value Fund (VEVIX) is my top-rated Mid-cap Value mutual fund. Both earn my Neutral rating. For those investors who are priced out by VEVIX’s $2.5 million initial minimum, VEVYX offers the same holdings for only slightly higher costs.

Guggenheim S&P Midcap 400 Pure Value (RFV) is my worst-rated Mid-cap Value ETF and Munder Integrity Mid-cap Value Fund (MAIMX) is my worst-rated Mid-cap Value mutual fund. RFV earns my Dangerous rating and MAIMX earns my Very Dangerous rating.

Figure 3 shows that 399 out of the 2,160 stocks (over 23% of the market value) in Mid-cap Value ETFs and mutual funds get an Attractive-or-better rating. Given the amount of quality stocks available for ETF providers and mutual fund managers to choose from, there really should be some Attractive rated ETFs or mutual funds in the Mid-cap Value style.

The fact that no funds allocate enough value to Attractive-or-better rated stocks to earn an Attractive rating reflects poorly on both passive and active management.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Mid-cap Value ETFs hold poor quality stocks.

Sources: New Constructs, LLC and company filings

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Mid-cap Value ETFs and mutual funds, as 10 out of 12 ETFs (97% of total net assets) and 150 out of 189 mutual funds (86% of total net assets) in the Mid-cap Value style earn a Dangerous-or-worse rating. Investors in this style should focus on individual stocks instead.

Covidien plc (COV) is one of my favorite stocks held by Mid-cap Value ETFs and mutual funds and earns my Very Attractive rating. COV has grown after tax profit (NOPAT) by 14% compounded annually over the past five years. Consistent NOPAT growth helps COV to have an impressive return on invested capital (ROIC) of 13%. COV has been proactive in recent years growing its product lines as well as expanding its business into Asia and Latin America. The steady rise in COV’s ROIC attests to the success of this strategy. Despite its recent profit growth, COV is priced for permanent profit decline. At its current valuation of ~$64.23/share, COV has a price to economic book value ratio of 0.9, implying that COV’s NOPAT will permanently decline by 10%. Strong recent growth combined with low market expectations makes COV a stock poised for success.

EchoStar Corporation (SATS) is one of my least favorite stocks held by Mid-cap Value ETFs and mutual funds and earns my Very Dangerous rating. The outlook for SATS looks bleak. Its 2% ROIC is nowhere near high enough for the company to achieve economic profitability. SATS $2.8 billion in total debt is a concern as well given that its NOPAT was only $100 million last year and it had free cash flow of negative $300 million. Given its meager cash flows and significant debt, SATS currently has an economic book (zero growth) value of negative ~$4.07/share. However, SATS is currently valued at ~$39.29/share. To justify this high valuation, SATS would need to grow NOPAT by 16% compounded annually for 17 years. Low cash flow, significant debt, and a high valuation make SATS too risky for investors.

Figures 4 and 5 show the rating landscape of all Mid-cap Value ETFs and mutual funds.

My Style Rankings for ETFs and Mutual Funds report ranks all styles and highlights those that offer the best investments.

Review my full list of ratings and rankings along with reports on all 12 ETFs and 189 mutual funds in the Mid-cap Value style.

Sam McBride contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style or theme.