Summary The ETFs, HACK and CIBR, overlap on 23 companies, six of which are among the top-ten holdings of each fund. Given the strength of the performance of some of the companies on which the ETFs overlap, it seems plausible to derive a smaller portfolio that would outperform either ETF. I consider two portfolios made up of holdings shared by both ETFs, and consider whether the performance gains are worth the tradeoff in security. When looking at a new ETF, I often find myself wondering if – given the ETF’s portfolio – there was a subset of that portfolio that would outperform the ETF itself, and not just outperform it, but outperform it by a significant amount . 1 How would one go about identifying that subset? I began thinking about this in detail as I wrote my last article, a comparison of two new ETFs – the PureFunds ISE Cyber Security ETF (NYSEARCA: HACK ) and the First Trust NASDAQ CEA Cybersecurity ETF (NASDAQ: CIBR ). 2 The funds, which take two fairly different approaches to investing in cybersecurity, have holdings that overlap with 23 companies. What I thought was particularly interesting was that the top-ten holdings in each portfolio overlapped on six companies. The funds weighted their holdings differently, with HACK having a modified equal-weighting structure, and CIBR being weighted according to market liquidity over the preceding 90 days. Would stocks in these companies outperform either or both ETFs? Group I The six companies that were among the top-ten-weighted holdings in both portfolios are: Cisco Systems, Inc. (NASDAQ: CSCO ) Fortinet, Inc. (NASDAQ: FTNT ) Imperva, Inc. (NYSE: IMPV ) Palo Alto Networks, Inc. (NYSE: PANW ) Proofpoint, Inc. (NASDAQ: PFPT ) Trend Micro Inc. ( OTCPK:TMICY ) The question: could holdings in these six companies ( Group I ) be reasonably expected to outperform HACK and/or CIBR? To answer the question, I traced the portfolios of the two ETFs back to August 1, 2010, and charted their performance through August 31, 2015. 3 I then tracked Group I apart from the ETFs. Each portfolio started with a $25,000.00 stake. 4 The results: (click to enlarge) Group I quite clearly outperformed both ETFs, growing the initial stake to $88,971.99 (a gain of more than 255% ), compared to HACK with $55,925.78 (~ 123%) and CIBR with $57,892.92 (~ 131%). A difference in growth of that magnitude over a period of five years certainly seems significant, by just about any standards. In principle, it would seem rational for an investor to choose to invest in the six companies that make up Group I rather than investing in either of the ETFs. A Caveat But while it might seem to be a good bet to buy shares in the Group I companies, upon closer examination there are some problems to consider. The following table lists some of these companies’ fundamental data: Of the six companies, only Cisco , Fortinet and Trend Micro stand up to close scrutiny. Each one is profitable; 5 all have manageable debt ( Cisco has the highest debt/equity ratio, at 0.44%, but its quick ratio is a very healthy 3.15); gross margin and operating margin for each are comparable to or better than those of their peers. The remaining three companies – Imperva , Palo Alto and Proofpoint – present a significantly different picture. None of these companies has made a profit in the five-plus years represented in the test; indeed, these companies have been losing substantial amounts of money annually. The companies have financed operations through sale of shares – thus diluting shareholders’ holdings – and by incurring debt. Only Imperva has maintained a low D/E ratio, with Palo Alto ‘s D/E rising just above 1, and Proofpoint ‘s D/E topping out at 3.78. Readers familiar with my approach to companies know that I focus heavily on fundamentals, particularly operating margin, returns, debt/equity and quick ratio. Only Cisco and Trend Micro come close to meeting my usual minimum standards. 6 Investing in companies that have a losing track record is a very subjective enterprise. On the one hand, I dismiss companies that habitually post losses out of hand; on the other hand, not all “losing” companies are bad bets. But investing in one requires that one take a leap of faith, and it’s not a leap to be taken lightly. I highly recommend serious study of such a company before investing in it. 7 Group II To go around the problem of investing in “losing” companies, I graded the 23 holdings over which HACK and CIBR overlapped. Interestingly, nine of those companies were operating in the red, and since operating margin and the three returns count heavily in my ranking system, those nine companies were excluded. Three more companies were excluded because they are foreign (this includes Trend Micro , even though it is one of the companies in Group I ). I still feel uncertain about foreign investments. After ranking the 11 companies remaining, I ended up with the following set of five stocks to make up Group II : 8 Check Point Software Technologies Ltd. (NASDAQ: CHKP ) CyberArk Software Ltd. (NASDAQ: CYBR ) F5 Networks, Inc. (NASDAQ: FFIV ) Qualys, Inc. (NASDAQ: QLYS ) VASCO Data Security International, Inc. (NASDAQ: VDSI ) The following table shows their “vital statistics”: In principle – on the basis of their fundamentals – I would consider these to be the top five of the 23 companies shared by the two ETFs. How do they perform? I subjected Group II to the same test I ran for Group I , with the following results: (click to enlarge) While it is clear that Group II does markedly better than either HACK or CIBR, it is also clear that it falls far short of the performance of Group I . The following chart shows how the two groups compare: (click to enlarge) Group I clearly outperforms Group II and does so quite handily, with its growth outpacing the latter group by more than 25%. I’m not certain that this means Group I is the better set of stocks, though; consider this chart: (click to enlarge) The past 20 months or so have been rough on the market in general, and particularly so for tech stocks. The spring of 2014 saw tech stocks take a hit with no general, significant driving force other than that the stocks were perceived as overvalued; this past summer saw the market as a whole go through a “correction” attributed to ((a)) growing concern over weakness in the Chinese economy , ((b)) a perceived weakening of the economic recovery in America , ((c)) a meltdown in oil prices , and ((d)) the prospect of the Fed raising interest rates . It is interesting to note, then, that Group II outperformed Group I during the stretch from January 1, 2014, through August 2015. The difference is not great, all things considered, but it serves to remind investors that a stock’s (or a portfolio’s) performance is dependent upon the perspective from which it is viewed. Assessment Moreover, since we are supposed to acknowledge that we cannot infer future performance simply on the basis of past performance, we need to look at an investment from a variety of perspectives. There is a distinct difference between the market of 2010 – 2013 and the market of 2014 – mid-2015 . The former was a significant part of the extended bull market that led the economy out of the Great Recession; the latter has been a period where the bull market has weakened (and maybe died), culminating in a summer-long correction . There is no surprise that stocks are going to rise (some, dramatically) when the market is hot; the surprise would be those companies that (continued to) drop in value. On the other hand, when the market in general is stumbling, one should maybe take note of performance that seems to “buck” the trend by showing a little strength; during such a period, 1200bps may have no small significance in comparing the relative strengths of a couple of portfolios. Looking at Group I , Imperva , Palo Alto and Proofpoint are losing money annually and persistently. According to Capital Cube, all three stocks are overvalued; Palo Alto has lost over $375 million in the past two years, yet currently commands a price over $179.00/share – with key valuations well in excess of its peers. 9 The stocks in Group II , on the other hand, have maintained solid fundamentals. Three of the companies ( Check Point , CyberArk and Qualys ) are perhaps overpriced, but Check Point is posting solid numbers comparable to F5 and VASCO , and none of the companies seems to be showing any problem areas. Being somewhat (!) risk averse, I would likely prefer the holdings listed in Group II , perhaps with Cisco (or Trend Micro ) added for good measure. However The advantage of an ETF such as HACK or CIBR is that one does not have to worry about the performance of the individual stocks in one’s portfolio – that is the fund manager’s job. There is a tradeoff involved, and it is up to the individual investor to decide if the prospective loss of growth that might be realized by investing in a basket of stocks is worth the work involved in choosing and monitoring a hand-picked selection of individual holdings. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s SEC filings to the extent possible. All tables, charts and graphs are produced by me using pertinent SEC filings as provided by Capital Cube ; historical price data is from The Wall Street Journal . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. ——————– 1 Of course, what counts as a “significant amount” is fairly subjective. A 25% improvement would be significant, I should think, but would 5% be significant – and in one year? Five years? I should think there would be a correlation between the length of time one was discussing and the level one would consider “significant” an improvement of 1000bps (when speaking of performance), or 10% (when talking about value) over five years would seem to be a safe margin to consider significant – while an improvement of 500 bps (or 5%) over 2 years would be perhaps a little less significant. Also, we can ask what it means to be “significant.” Again, this is fairly subjective, but let’s suppose we’re talking about the level of difference at which one would seriously consider investing in the subset, rather than in the ETF itself. I might consider the chance of a 2% improvement over the first year to be enough to convince me, while someone else might not be convinced with anything less than 5%. Yet another person might opt for the ETF even if there was reasonable prospect of improving the payout by 25% by investing in the subset. 2 ” 2 New ETFs Track Cybersecurity Growth ,” Seeking Alpha , August 24, 2015. 3 While the ETFs are new within the past nine months, I traced the performance of their portfolios as they existed on August 21, 2015, maintaining the same weighting throughout as they had on that date. Companies that did not start trading until after August 2010 were added during quarterly rebalancing and reconstitution; funds that would have applied to those companies were held in reserve until they “formally” joined the portfolio. To differentiate between the ETFs and the extension of their portfolios, I will refer to the portfolios as HACKʹ and CIBRʹ . Please note that the data for their portfolios is not intended to indicate how the ETFs themselves would have performed over the same period. 4 The portfolios for HACKʹ and CIBRʹ were weighted according to note 3 above. Group I was weighted equally. All portfolios were rebalanced and reconstituted quarterly. 5 For the period of the test (August 2010 – present) each of the three companies has recorded net profit for each of the years included. 6 In many of my articles I rely on a fairly small set of fundamental criteria that emphasize efficiency, effective management and financial responsibility. In the past, my basic standards were: OM > 25%; RoE, RoA and RoI > 15%; D/E < 0.5; QR > 1. 7 For my part, I have a moderate stake in Neuralstem, Inc. (NASDAQ: CUR ), and have had one for a few years. It has not made a profit since before I bought shares. I did my homework before investing in Neuralstem, and while its fundamentals are very weak, I believe that their business – and the science behind it – is sound, and all indications are that it will, in the very near future, show some of the enormous promise it has. Before it took a serious dive this year, it had been a four-bagger for me. 8 The number five is totally arbitrary. A group of six or more (or four or less) might work, but five seems like a nice number to work with. As luck would have it, an extension to six would have included Cisco, which missed membership in Group II by only a few points. 9 See here , for instance. Also, as a matter of fact, according to Capital Cube only Cisco – out of all of Group I – is undervalued. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long CUR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.