VAW: Materials Dashboard For September (NYSEARCA:VAW)

This monthly article series shows a dashboard with aggregate industry metrics in materials. It is also a review of sector exchange-traded funds, or ETFs, like Materials Select Sector SPDR 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 the last trading day’s closing. Columns stand for all the data named and defined above.

Click to enlarge

Value and Quality chart

The next chart plots the Value and Quality Scores by industry (higher is better).

Evolution Since Last Month

The value score has slightly deteriorated in mining/metals and improved in other subsectors.

Momentum

The next chart plots momentum scores based on median returns.

Interpretation

The materials sector was very close to 11-year averages in valuation and quality metrics when I published my S&P 500 dashboard for September. The construction materials subsector is the most attractive one: it is undervalued by 36% relative to the historical baseline and shows an excellent quality score. Chemicals and packaging are on their baseline in valuation, and close to it in quality. Mining/metals looks significantly overvalued.

Fast facts on VAW

Vanguard Materials ETF has been tracking the MSCI US IMI Materials 25/50 Index since 01/26/2004. It has a total expense ratio of 0.10%, the same as XLB. It is also available as a mutual fund (VMIAX).

The fund has 115 holdings, but it is quite concentrated. The top 10 companies, listed in the next table, represent 50.7% of asset value. The top name, Linde Plc, weighs over 15%. Risks related to other companies are moderate.

Click to enlarge

Ratios from Portfolio123.

VAW has outperformed XLB in total return since inception (see next table). However, the difference in annualized return is insignificant: only 39 bps. The risk is also similar, as reported below in drawdown and volatility metrics.

Click to enlarge

Data calculated with Portfolio123.

VAW is a good product for investors seeking capital-weighted exposure in basic materials. Its portfolio holds 115 stocks from large to small caps, whereas XLB invests in only 32 large companies. VAW is less concentrated in the top holdings: LIN weighs 15.4% vs. 20.7% in XLB. Nevertheless, the difference in annualized return since inception is insignificant. XLB has much higher trading volumes, which makes it a better instrument for trading and tactical allocation. Investors who are concerned by risks related to the top holding weight may 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 0.0431 (or price/earnings below 23.20) is in the better half of the industry regarding this metric. A Dashboard List is sent every month to Quantitative Risk & Value subscribers, with the most profitable companies standing in the better half among their peers regarding the three valuation metrics at the same time. 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.