IWF - IWD: There Could Be Considerable Downside Risk

2023-09-18 13:20:24 ET

Summary

• IWD invests in value stocks in the Russell 1000 index.
• A significant portion of its portfolio consists of sectors that are sensitive to the strength of the economy.
• IWD's current valuation is towards the high end of its historical average.

Introduction

Value investing is an interesting strategy as it selects stocks with lower valuations, thus reducing the downside risk of owning higher valuation stocks. However, is this really a good strategy, especially for investors with a long-term investment horizon? In this article, we will analyze iShares Russell 1000 Value ETF ( IWD ) and provide our insights.

ETF Overview

IWD owns a portfolio of U.S. large-cap value stocks in the Russell 1000 index. These stocks are currently trading towards the high end of their historical valuation range. In addition, a significant portion of its portfolio consists of stocks that are sensitive to the strength of the economy. As the Federal Reserve is still battling against high inflation and a rate cut is not likely in the near-term, we think the economy may eventually head for a mild recession. In such a scenario, stocks in IWD's portfolio may eventually see its earnings being revised downward. This will eventually result in downward pressure to IWD's fund price. Hence, we do not think this is the right moment to invest in IWD.

Fund Analysis

IWD has been in rangebound in 2023

IWD has delivered a total return of 6.2% in 2023 so far. The fund has been rangebound in 2023. This performance is much lower than the Russell 1000 index. As can be seen from the chart below, iShares Russell 1000 ETF ( IWB ) delivered a total return of 18.44% in 2023 year-to-date. This is not surprising as IWB includes more technology stocks than IWD and technology stocks have outperformed the entire market in 2023. In fact, technology stocks represent over 26% of IWB's portfolio and only about 9% of IWD's portfolio.

IWD has considerable exposure to economically sensitive sectors

Let us analyze IWD’s portfolio composition. As can be seen from the chart below, the financials sector is the largest sector in IWD’s portfolio, as it represents 20.65% of the total fund. Health care and industrials sectors represent 15.23% and 12.99% of IWD’s portfolio respectively. While the health care sector is defensive in nature, financials and industrials sectors are sensitive to the strength of the economy. In fact, IWD has considerable exposure to sectors that depends on the strength of the economy. These sectors include financials, industrials, energy, consumer discretionary, real estate, and materials sectors. Together, these sectors represent over 57% of the total portfolio.

Valuation is expensive relative to its historical average

Below is a chart that shows the valuations of growth and value stocks in the S&P 500 index. While one may argue that the S&P 500 index is not the same as the Russell 1000 index, all of the stocks in the S&P 500 index are included in the Russell 1000 index. Therefore, there is considerable overlap and still provides insightful information for our analysis. As can be seen from the chart below, value stocks have an average forward P/E ratio of 16.5. As can be seen from the chart, value stocks’ average forward P/E ratio has usually been in the range of 11x and 18x since 2000. Therefore, its current forward P/E ratio of 16.5 is towards the high end of this valuation range.

As the economy continues to weaken, earnings will likely be revised lower

Let us take a look at the macroeconomic environment. While the Federal Reserve has raised its rate aggressive in 2022 and in early 2023, August's core CPI of 4.3% growth from a year ago means there is still a long way to go for the Federal Reserve to bring down the inflation to its 2% target. Hence, we do not anticipate the Federal Reserve will lower its fund rate any time soon. The recent surge in oil prices may make it even harder for the Federal Reserve to bring down the inflation to its target. If the inflation flares up again, the Federal Reserve may need to raise the rate further, albeit at a slower pace.

In this environment, we think the economy may eventually head for a recession. With a recession not far away, we think earnings of many companies will likely be revised downward. As the economy continues to weaken, it is difficult for value stocks to hold on to the current valuation towards the high end of the historical range. Therefore, there is considerable downside risk.

Investor Takeaway

Value investing is a good investing strategy to reduce downside risks. However, we see considerable downside risk right now, especially given the macroeconomic environment we are in. Hence, we advise investors to wait on the sidelines.

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