VAW: Materials Dashboard For July (NYSEARCA:VAW)

Adam Lubroth This monthly article series shows a dashboard with aggregate industry metrics in materials. It is also a review of sector ETFs like The Materials Select Sector SPDR® Fund ETF (XLB) and Vanguard Materials Index Fund ETF Shares (NYSEARCA:VAW), whose largest holdings are used to calculate these metrics. Shortcut The next two paragraphs in italic describe the dashboard methodology. They are necessary for new readers to understand the metrics. If you are used to this series or if you are short of time, you can skip them and go to the charts. Base Metrics I calculate the median value of five fundamental ratios for each industry: Earnings Yield (“EY”), Sales Yield (“SY”), Free Cash Flow Yield (“FY”), Return on Equity (“ROE”), Gross Margin (“GM”). The reference universe includes large companies in the U.S. stock market. The five base metrics are calculated on trailing 12 months. For all of them, higher is better. EY, SY and FY are medians of the inverse of Price/Earnings, Price/Sales and Price/Free Cash Flow. They are better for statistical studies than price-to-something ratios, which are unusable or non-available when the “something” is close to zero or negative (for example, companies with negative earnings). I also look at two momentum metrics for each group: the median monthly return (RetM) and the median annual return (RetY). I prefer medians to averages because a median splits a set in a good half and a bad half. A capital-weighted average is skewed by extreme values and the largest companies. My metrics are designed for stock-picking rather than index investing. Value and Quality Scores I calculate historical baselines for all metrics. They are noted respectively EYh, SYh, FYh, ROEh, GMh, and they are calculated as the averages on a look-back period of 11 years. For example, the value of EYh for packaging in the table below is the 11-year average of the median Earnings Yield in packaging companies. The Value Score (“VS”) is defined as the average difference in % between the three valuation ratios ((EY, SY, FY)) and their baselines (EYh, SYh, FYh). The same way, the Quality Score (“QS”) is the average difference between the two quality ratios ((ROE, GM)) and their baselines (ROEh, GMh). The scores are in percentage points. VS may be interpreted as the percentage of undervaluation or overvaluation relative to the baseline (positive is good, negative is bad). This interpretation must be taken with caution: the baseline is an arbitrary reference, not a supposed fair value. The formula assumes that the three valuation metrics are of equal importance. Current data The next table shows the metrics and scores as of writing. Columns stand for all the data defined above. VS QS EY SY FY ROE GM EYh SYh FYh ROEh GMh RetM RetY Chemicals -9.15 -4.80 0.0305 0.5128 0.0170 16.22 42.19 0.0420 0.4478 0.0199 17.85 42.39 1.59% 7.40% Constr. Materials -7.67 37.61 0.0440 0.5853 0.0367 21.25 36.29 0.0410 0.7899 0.0384 13.72 30.17 1.51% 18.00% Packaging -12.74 0.47 0.0447 1.0752 0.0240 16.97 27.60 0.0491 1.0349 0.0359 18.54 25.23 0.18% -3.01% Mining/Metals -5.11 0.52 0.0455 0.8628 0.0260 8.60 23.32 0.0419 1.1517 0.0257 9.43 21.23 6.52% 6.20% Click to enlarge Value and Quality chart The next chart plots the Value and Quality Scores by industry (higher is better). Value and quality in materials (Chart: author; data: Portfolio123) Evolution since last month The value score has materially deteriorated in mining/metals, and to a lesser extent in construction materials. Score variations (Chart: author; data: Portfolio123) Momentum The next chart plots momentum scores based on median returns. Momentum in Materials (Chart: author; data: Portfolio123) Interpretation According to my monthly S&P 500 dashboard, the basic materials sector is moderately overvalued based on 11-year averages. Mining/metals, construction materials and chemicals are overvalued by less than 10% relative to the historical baseline, while packaging is overvalued by about 13%. Construction materials still look relatively attractive based on its excellent quality score. The quality score of other subsectors is close to the baseline. Fast facts on VAW Vanguard Materials Index Fund ETF Shares has been tracking the MSCI US IMI Materials 25/50 Index since 01/26/2004. It has a total expense ratio of 0.10%, similar to XLB (0.09%). It is also available as a mutual fund (VMIAX). The portfolio has 119 holdings and is quite concentrated: the top 10 holdings, listed in the next table, represent 51.6% of asset value, and the largest position, Linde Plc, weighs 15.9%. Risks related to other companies are moderate. Ticker Name Weight EPS growth %TTM P/E TTM P/E fwd Yield% LIN Linde Plc 15.94% 43.18 34.51 28.73 1.25 SHW The Sherwin-Williams Co. 5.43% 14.98 34.33 28.30 0.89 FCX Freeport-McMoRan Inc. 5.25% -36.46 40.34 27.72 1.31 ECL Ecolab Inc. 4.61% 34.09 45.01 36.89 0.94 APD Air Products & Chemicals, Inc. 4.32% 13.66 23.79 21.48 2.69 CRH CRH plc 3.88% -14.77 18.47 14.83 1.75 NEM Newmont Corp. 3.63% -304.13 N/A 16.85 2.13 NUE Nucor Corp. 2.87% -33.39 9.56 15.10 1.33 CTVA Corteva, Inc. 2.84% -51.79 69.86 19.70 1.17 DOW Dow Inc. 2.81% -58.10 32.15 18.65 5.19 Click to enlarge Ratios from Portfolio123. VAW has outperformed XLB by about 40% in total return since inception. However, the difference in annualized return is hardly significant (38 bps). VAW is marginally more volatile, as reported in the next table. The two funds have the same risk-adjusted performance measured by Sharpe ratio. Total return Annualized return Max Drawdown Sharpe ratio Volatility VAW 496.38% 9.12% -62.17% 0.43 20.88% XLB 455.95% 8.74% -59.83% 0.43 20.11% Click to enlarge Data calculated with Portfolio123. VAW is designed for investors seeking capital-weighted exposure to the basic materials sector. Its portfolio holds 119 stocks from large to small caps, whereas XLB invests in only 31 larger companies. VAW is a bit less concentrated in the top holdings: in XLB, the top 10 holdings represent 66.1% of asset value and LIN weighs 20.8%. Nevertheless, the difference in annualized return since inception is insignificant. VAW and XLB are equivalents for long-term investors. XLB is a better instrument for trading and tactical allocation thanks to higher trading volumes. Investors who are concerned by the risk related to the top holding would likely prefer Invesco S&P 500 Equal Weight Materials ETF (RSPM). Dashboard List I use the first table to calculate value and quality scores. It may also be used in a stock-picking process to check how companies stand among their peers. For example, the EY column tells us that a chemical company with an Earnings Yield above 0.0305 (or price/earnings below 32.79) is in the better half of the industry regarding this metric. A Dashboard List is sent every month to our subscribers with the most profitable companies standing in the better half among their peers regarding the three valuation metrics at the same time. The stocks below are part of the list sent to subscribers a few weeks ago. CE Celanese Corp. BLDR Builders FirstSource, Inc. APOG Apogee Enterprises, Inc. GFF Griffon Corp. OC Owens Corning Click to enlarge It is a rotational model with a statistical bias toward excess returns on the long-term, not the result of an analysis of each stock.

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