PPG - FMAT: Materials Dashboard For October

2023-10-16 14:48:33 ET

Summary

• The construction materials industry has the best value and quality scores in the sector.
• Mining/metals still is the most overvalued sub-sector, despite a significant improvement in the last month.
• Fidelity® MSCI Materials Index ETF is an alternative to XLB.

This monthly article series shows a dashboard with aggregate industry metrics in materials. It is also a top-down analysis of sector exchange-traded funds, or ETFs, like Materials Select Sector SPDR® Fund ETF ( XLB ) and Fidelity® MSCI Materials Index ETF ( FMAT ), whose largest holdings are used to calculate these metrics.

Shortcut

The next two paragraphs in italics 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 the 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 last week's closing. Columns stand for all the data named and defined above.

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 improved in all sub-sectors, the most in mining/metals.

Momentum

The next chart plots median returns by sub-sector.

Interpretation

The construction materials industry has the best value and quality scores in the sector. Packaging is close to its historical baseline in valuation and has a good quality score. Chemicals are undervalued by about 8% relative to 11-year averages, but quality is slightly below the baseline. Mining/metals still is the most overvalued sub-sector, despite a significant improvement in the last month.

Focus on FMAT

Fidelity MSCI Materials Index ETF has been tracking the MSCI US IMI Materials 25/50 Index since 10/21/2013. It has a total expense ratio of 0.08%: it is a bit cheaper than Vanguard Materials ETF ( VAW ), which tracks the same index for 0.10%, and XLB, which tracks a large cap index also for 0.10%.

The fund has 124 holdings. The next table lists the top 10 names with fundamental ratios and dividend yields. The portfolio is quite concentrated: their aggregate weight is close to 51%. Nonetheless, it is better diversified than XLB, whose top 10 holdings represent 65% of assets, and where Linde Plc weighs over 20%.

FMAT and VAW share the same underlying index, and they have almost identical annualized returns since FMAT inception. Their maximum drawdown and volatility are also almost identical. As VAW is older, I will use it to assess the index performance on a longer period.

VAW has outperformed XLB by a short margin of 36 bps in annualized return since 2/2/2004. Their risk-adjusted performances are also close (Sharpe ratio in the next table).

Data calculated with Portfolio123.

In summary, FMAT is a good product for investors seeking capital-weighted exposure in basic materials. It currently holds 123 stocks including large, mid- and small caps, whereas XLB has only 32 holdings in larger companies. Buy-and-hold investors may prefer Fidelity® MSCI Materials Index ETF because of a cheaper expense ratio, but liquidity makes XLB a better choice for tactical allocation and swing trading. Investors who are concerned by risks related to the top holding (16% of assets) 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 0.0461 (or price/earnings below 21.69) 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 in the long term, not the result of an analysis of each stock.

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