RXI - FDIS: Keeping Faith In The Consumer

2023-11-13 01:24:58 ET

Summary

• Despite an unprecedented rate hike cycle, the consumer remains in great shape.
• Consensus earnings estimates look poised to climb a wall of worry in the near term.
• Discretionary-focused ETFs aren't all that pricey adjusted for their high-multiple 'Magnificient 7' constituents.

The New York Fed's 'Household Debt and Credit' report for Q3 has raised some alarms, with delinquent balances rising for the quarter, particularly in consumer-centric categories like credit card debt and auto loans. Adding to concerns is the additional student loan repayment burden, which, combined with tighter rate-driven financial conditions, could place further upward pressure on delinquencies in the coming quarters.

For the most part, though, the overall strength in household balance sheets is intact, while consumer confidence (per the Conference Board index) and jobs data have also been relatively resilient. And while the consumer discretionary sector screens expensively at a ~23x earnings multiple for the ultra-low-cost Fidelity MSCI Consumer Discretionary Index ETF (FDIS), the headline multiple is distorted by two uber-caps - Amazon ( AMZN ) and Tesla (TSLA). The median earnings multiple, on the other hand, is closer to the low teens, already reflecting fears of a consumer spending slowdown. Against a backdrop of positive revisions in recent months and a steady low-teens % earnings growth outlook next year, I like the FDIS risk/reward here.

Fund Overview - Ultra Low-Cost Consumer Discretionary Basket

The Fidelity MSCI Consumer Discretionary Index ETF tracks (pre-expenses) the performance of the MSCI USA IMI Consumer Discretionary Index, a basket of the largest US-listed consumer discretionary names. FDIS is one of the smaller discretionary ETFs on the market at $1.1bn of net assets - by comparison, key ETF comparables like the Consumer Discretionary Select Sector SPDR Fund ( XLY ) and the Vanguard Consumer Discretionary ETF manage $16.2bn and $5.4bn, respectively. The fund makes up for its lower liquidity with a lower expense ratio of 0.08%, a 2bps discount to XLY and VCR.

For the most part, FDIS' portfolio composition doesn't deviate too far from comparable discretionary pure-play ETFs. Like its peers, Broadline Retail is the largest industry exposure at 26.4%, followed by Hotels, Restaurants & Leisure (21.3%), Specialty Retail (20.2%), and Automobiles (15.3%). Outside of Textiles, Apparel & Luxury Goods, no other industry has a >5% allocation.

Similarly, FDIS, like the other discretionary ETFs, has its single stock portfolio concentrated around two mega-cap discretionary franchises, AMZN and TSLA, at a combined 37.0%. Other meaningful blue-chip holdings include Home Depot ( HD ) at 6.5% and McDonald's ( MCD ) at 4.4%. As its top ten stocks contribute 61.9% of the overall portfolio, investors should be aware of the concentration risks.

Fund Performance - Steady Compounder Through the Cycles

Unlike consumer staples (see prior coverage of the equal-weighted Invesco S&P 500 Equal Weight Consumer Staples ETF ( RSPS ) here ), the discretionary sector has been a YTD outperformer. FDIS has returned +7.3% over the last year, outpacing XLY (+6.6%) and matching VCR (+7.3%). Over longer timelines, the fund has delivered similarly strong annualized returns at +10.9% and +11.2% over the last five and ten years, respectively. The only caveat here is the relatively wide tracking error vs. its benchmark MSCI USA IMI Consumer Discretionary Index, though the industry-leading expense ratio helps offset some of the impact.

In line with other discretionary ETFs, FDIS' strong capital growth comes at the expense of income. The fund's quarterly distribution is currently running at 0.9% on a trailing twelve-month basis, while its 30-day SEC yield stands ~10bps lower at ~0.8%. Given the sector's history of low capital returns, a result of the sector's key constituents having rich reinvestment opportunities and earnings growth potential, I don't expect yield upside anytime soon. Portfolio valuations also screen highly at 23.1x earnings, largely skewed by FDIS' two largest holdings (TSLA and AMZN), but well matched by a +32.0% historical earnings growth algorithm.

Some Blemishes in the Economic Data but Consumer Resilience Shines Through

There's been some concern about the state of the consumer following this month's New York Fed report highlighting rising credit card debt (now at a record $108tn) and delinquency rates in Q3. Similarly, new delinquencies (>30 days late) are up in consumer-centric categories (e.g., credit cards and auto loans). Given that younger borrowers, many of whom are driving the delinquency rates, will be hit by the resumption of student loan repayments (starting last month), the path ahead probably won't be as straightforward as before.

For the most part, though, the report shows that US households still repay their debt on time. Meanwhile, seriously delinquent balances (>90 days late), as well as overall foreclosures and bankruptcies, despite rising for yet another quarter, remain near all-time lows - impressive given the extent to which the Fed has hiked rates over the last year.

Beyond the Fed report, there have been many other positive consumer data points as well. Take October's consumer confidence index (tracked by the Conference Board here ), for instance, which, despite being down ~1.7% percentage points for the month (now back to May levels), still came in well above consensus expectations. Digging deeper, the index decline was mainly down to the present situation (i.e., an assessment of current business and labor market conditions) and expectations indices (i.e., consumers' assessment of the income, business, and labor market near-term outlook) edging down, while the all-important labor differential (i.e., an assessment of employment conditions) moved higher.

The positive labor assessment validates the job market resilience shown by consecutive months of payroll expansion, as well as new highs for the improved job vacancies to hires ratio and average reservation wage; combined, these data points bode well for continued wage strength. In turn, forward earnings growth expectations for the sector (low-teens % per consensus estimates), having already seen a wave of positive revisions over the last few months, could still see more upside from here.

Keeping Faith in the Consumer

US consumer discretionary stocks have defied headwinds from elevated interest rates this year, notching one of their best years on record. While concerns about the state of the consumer have re-emerged following spots of weakness within the Fed's Q3 household debt and credit report, the overarching picture remains that of resilience.

Even if a higher delinquencies scenario materializes in the near future, there's more than enough capacity in existing consumer balance sheets to navigate the storm. Plus, there's the insulation from an increasingly termed out, fixed-rate household debt mix, as well as resilient jobs and consumer confidence data to factor in, which combined, indicate a protracted consumer slowdown seems unlikely from here.

Adjusting out the high multiple uber-caps, discretionary-focused ETFs like FDIS don't screen all that pricey here and should appreciate alongside more positive earnings revisions ahead.

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