iShares Core S&P Total US Stock Market ETF (NYSEARCA:ITOT) is an exchange-traded fund that offers investors exposure to the “total” US stock market, meaning the portfolio spans a long way, including both ultra-large cap companies in the form of small cap stocks. The fund had assets under management of $41.1 billion as of May 27, 2022, which makes it very popular, while the expense ratio is only 0.03%, which makes the fund also very good market (probably in part due to the high popularity of ITOT).
ITOT held 3,626 holdings as of May 27, 2022, but the fund was still reasonably concentrated at the top, as you would expect with virtually any large equity fund. Still, the fund is less concentrated than typical US equity ETFs that track indices like the S&P 500. ITOT’s top 10 stocks made up 22.33% of the fund as of May 27, 2022.
ITOT’s chosen benchmark, which it is designed to roughly track, is the S&P Total Market Index. A recent fact sheet for the fund, dated April 29, 2022, revealed a price-to-earnings ratio of 22.28x, a forward price-to-earnings ratio of 18.91x, a price-to-book ratio of 3, 79x and an indicative dividend yield of 1.48%. Based on this information, I know that the projected ROE for ITOT’s underlying portfolio is around 20% (almost exactly) and its dividend payout ratio (of earnings) is around 33%. .
A 20% ROE is strong. However, among the S&P 500, the redemption rate (of earnings) is around 50%, which is in addition to dividend distributions. I’ll assume a 30% decline due to less concentration of large cap stocks in the ITOT portfolio and hold that constant for now (we can play around with adjustments shortly, after a baseline estimate to work with ). Consequently, the strong ROE of 20% could even increase, as distributions (of dividends and redemptions) decrease the net asset values (the retained balance sheet sizes) of companies, decreasing the denominator (equity) in the equation. Nonetheless, I will try to be conservative in limiting earnings growth to 2% by year five.
The result of my estimates is that my three- and five-year average revenue growth rates are 13.82% and 9.77%, respectively, which is just below Morningstar’s consensus estimate (over three to five years) of 13.92%. So my projections are not unrealistic, apparently. I also assume that the price paid for stock buybacks is similar to the current price/earnings ratio on average, although I have decided to lower the forward price/earnings ratio slightly over time.
The end result is that the current price of the ITOT implies an IRR of 10.39-11.37%, depending on whether you value total earnings power or just distributions (plus terminal value).
Assuming a risk-free rate of around 3%, the implied equity risk premium is between 7.39% and 8.37%, which is high. I would consider 4.2-4.5% to be just the US equity risk premium without any beta adjustments (beta is a measure of relative volatility, or risk, and ITOT is basically just beta given its large level of diversification, so no adjustment is important here). A high ERP can go up to 5.5%. Thus, the current range of 7.39 to 8.37% according to my estimates implies an upside potential of more than a third (about 34%) for ITOT shareholders.
If I adjust the surrender rate to 0% or 50% and hold them constant in each scenario, my projected IRR goes to around 8.8-11.37% (in the no-surrender model) and 11.37- 11.49% (in the top model). redemption model). I will refer to my baseline estimates below, but even in the weakest scenario where redemptions stop completely, the IRR still implies an equity risk premium well over 5.5% (actually closer to 6%), which is high.
Since the ITOT is so diverse, my view is fundamentally bullish, not only on the ITOT, but also on the broader US stock market as a whole. ITOT itself is exposed to all kinds of sectors, including technology (24%), healthcare (14%) and financial services (14%).
There are some risks of a seemingly deepening recession, but based on Fidelity’s reasoned research, the United States is not yet in the latter stages of its current economic cycle. It is likely that the markets have taken a step ahead of themselves.
I’m betting on historic highs right now, before a “true high” forms in the later stages of the current economic cycle. Markets are believed to price major events like earnings recessions around 6-9 months ahead, but not much more. You also tend to see major yield curve inversions ahead of time, but yield curve inversions have been weak at best (the most believable indicator is the spread between US 10-year yields and US 3-month rates, and it hasn’t even reversed yet). All I see right now is a good opportunity for risk premia to contract again, i.e. valuations to rally and equities to higher highs before we have to worry of a recession and a bear market.
Therefore, in summary, ITOT is a diversified source of beta, with exposure to the entire US stock market. It is inexpensive to own and appears undervalued, based on historical measures of stock market risk. In a low-rate world, an IRR of around 10% is excellent. Following recent market declines, I would buy the dip.