The Schwab U.S. Large-Cap Growth ETF (NYSEARCA:SCHG) is one of Charles Schwab’s (SCHW) most popular index funds. Built on top of the Dow Jones Large Cap Growth Index, it is more diversified than the NASDAQ-100, with 247 stocks compared to the NASDAQ-100’s (you guessed it) one hundred.
From a bird’s-eye view, SCHG has a lot going for it. Among its stand out ‘fact sheet’ features are:
-
A five star Morningstar rating.
-
A 0.04% expense ratio.
-
4% portfolio turnover (lower is better).
-
16% CAGR returns (past performance doesn’t tell you future performance, but it is a good sign in pooled investment vehicles as it indicates the quality of the manager and/or index tracked).
-
247 stocks.
So, this fund has a lot to recommend it. It’s diversified, it’s cheap, it has done well historically. What more could you want?
Well, the fund does look pretty good from all the surface-level indicators. However, there are some concerns beneath the surface. For example, valuation. Although I called SCHG cheap a few paragraphs back, I meant it was cheap in the sense of having low fees. The holdings themselves are definitely not cheap, trading at 35.4 times earnings, 8.6 times book value, and 24.6 times cash flow. This is an even steeper valuation than the one the QQQ trades at!
However, SCHG undeniably has its positives. Its 247 stock portfolio gives it a lot more diversification than the QQQ has. Also, its 0.04% management expense ratio is lower than that fund’s fee (it’s lower than most funds’ fees, really).
Recently, I wrote an article on ProShares’ UltraPro QQQ ETF (TQQQ), in which I argued that the fund was too risky, despite its holdings being identical to those of the QQQ, which I had previously given bullish coverage. My rationale when writing that piece was that TQQQ used too much leverage, and that leverage had gotten more expensive over time, which would likely cause it to not actually triple the QQQ’s returns, and could even cause investors to lose 100% of their investment if a large one-day decline in QQQ stocks occurred. I still think that these are real concerns. Real enough that I rated ‘TQQQ’ a hold. However, on balance, I am more bullish than bearish on the QQQ (the fund that TQQQ is based on) itself.
I feel similarly about SCHG. Much like the QQQ, it’s pricey, and probably due for a near term correction, but worth the investment if you have a very long term (let’s say 10 years or more) timeframe.
In this article, I make the case that SCHG is a moderately good buy at today’s prices. Although its steep valuation means that a correction could be coming, the fund should nevertheless do well over the long term, even if bought at today’s comparatively high levels. Unlike TQQQ, the fund is not leveraged. This makes it much like QQQ itself. However, SCHG has enough things going for it that it is worth holding alongside, or in place of, that fund. In this article, I will explore these characteristics in detail, ultimately concluding that SCHG is a moderately good value today.
Holdings
When looking at any ETF, a good place to start is the holdings. It’s these along with the fund’s fees and spread that primarily determine investors’ returns. So, let’s take a look at SCHG’s holdings close up.
First, the big picture view:
-
SCHG has 247 stocks.
-
The biggest sector is information technology, with a 46.1% allocation.
-
The second biggest is communications services, with a 13% allocation.
-
The third biggest is healthcare (primarily med tech) with a 12.1% allocation.
-
Other sectors like financials and real estate combined make up 28.8% of the fund.
-
The three biggest holdings are Microsoft (MSFT), Apple (AAPL) and NVIDIA (NVDA).
Right away, you can spot the similarities with QQQ. The top three holdings are identical to that fund’s top three holdings, and the overweighting of IT and communications are also very QQQ-like. However, you also notice differences when looking at the list above:
-
Financials are part of SCHG’s portfolio, but excluded from that of the QQQ.
-
QQQ does not exclude small caps like SCHG does.
We can see at least one case for buying SCHG here right away: financial exposure. Financials have been one of the best performing sectors in the last year, rising 25.43% on a total return basis. Although that is a bit behind the S&P 500 in the same timeframe, it is better than the performance delivered by energy stocks, utilities and real estate in the period. Financials have a lot of catalysts that could drive growth in the year ahead. Most notably, they’re seeing an uptick in deal-making activity that’s driving higher investment banking (IB) fees. There are certainly issues in financials, but the high growth being observed in IB fees is, for this author at least, reason enough to have them in one’s portfolio. SCHG indeed “has them,” while the QQQ doesn’t.
Valuation
Having looked at SCHG’s holdings, we can now look at how it is being valued by the markets. Although I described the fund as “cheap” earlier, I was mainly referring to the direct cost of investing in the fund (i.e. the fees). The “price premium” paid is rather large, and in fact, larger than that of QQQ. As you can see in the table below, SCHG’s top components trade at very high multiples:
P/E |
Price/book |
Price/sales |
Price/cash flow |
|
Microsoft |
37 |
12.7 |
13.6 |
29.2 |
Apple |
32 |
42 |
8.4 |
28.7 |
NVIDIA |
67 |
60.5 |
37 |
73 |
Amazon (AMZN) |
52.4 |
8.9 |
3.3 |
19.7 |
Meta Platforms (META) |
29 |
8.6 |
9.1 |
16.9 |
Google Class A (GOOGL) |
27 |
7.5 |
6.96 |
20.4 |
Google Class B (GOOG) |
27 |
7.5 |
6.96 |
20.4 |
Eli Lilly and Company (LLY) |
119 |
60.85 |
21.7 |
212 |
Broadcom (AVGO) |
34 |
9.6 |
15.9 |
36 |
Tesla (TSLA) |
62.5 |
8.45 |
5.7 |
49.6 |
AVERAGES |
48.7 |
22.66 |
12.8 |
50.6 |
As you can see, the averages for SCHG’s top 10 holdings are outrageously high. However, almost all of Eli Lilly’s multiples are higher than average for this set. If we treat LLY as an outlier and remove it, then the P/E multiple shrinks to 40.8. Simply removing that stock might seem like wishful thinking, but it’s important to remember that Schwab reports a 36 P/E ratio for the whole portfolio. So, it seems likely that the relatively modestly valued names above, represent the entire SCHG portfolio better than the richly valued ones like Eli Lilly do.
If we assume that Schwab’s self-reported PE ratio of SCHG is correct, then we can do some discounted cash flow exercises to determine the value of the fund’s earnings.
A 36 PE ratio is equivalent to a $36 stock with $1 in earnings. If you discount $1 at the 10 year treasury yield (4.3%), assuming no growth, then you end up with a $23.25 fair value estimate. That’s about 55% off of the “$36” stock price. However, if we add a growth assumption, then we find many scenarios in which SCHG can be worth the investment. Examples include:
-
Five years of 10% growth followed by 5% in perpetuity thereafter, 6% discount rate: $132 fair value estimate.
-
Five years of 15% growth followed by 7% in perpetuity thereafter, 8% discount rate: $152 fair value estimate.
-
Five years of 20% growth followed by 4% in perpetuity thereafter, 8% discount rate: $51 fair value estimate.
All of these scenarios involve growth levels that SCHG has historically achieved. So, it does not take that much optimism to conclude that the fund is worth the investment.
Now, SCHG itself currently trades at $99.7, but its components’ weighted average earnings are higher than one. So, for example, the $51 FV estimate above is equivalent to a $150 price target on SCHG. The point is to show, using simplified numbers, that SCHG needs growth in order to be worth the investment. It does not, however, need a ridiculous amount of it.
Conclusion
On the whole, I consider SCHG a moderate-conviction buy. Like QQQ, it needs growth in order to be worth the investment today. Unlike QQQ, it includes financials, which results in its portfolio having the ability to benefit in scenarios where financials out-perform tech. It also has some basic characteristics that compare well with QQQ’s, such as a 0.04% MER and 247 stocks. On the whole, it’s worth owning, though maybe not at an overly high portfolio weighting. The valuation issues are serious enough that they could result in the fund treating investors to several lost years.
Read the full article here