RCD - PEJ: Ready To Roll The Dice?

2023-05-10 14:08:34 ET

Summary

• PEJ tracks an Index of 30 companies in the leisure and entertainment industries and reconstitutes quarterly. The expense ratio is 0.55%, and the ETF has $441M in assets under management.
• PEJ is an inconsistent performer, regularly ranking near the top or bottom compared to 13 other peers. Its compounded returns also lag passive alternatives like XLY and RCD.
• PEJ has a higher margin of safety than last year. Sales growth rates are 18%, primarily because PEJ avoids the retail industry, so I've upgraded my rating to a hold.
• Still, PEJ has substantial risks that should give even speculative investors some pause. This article discusses wage-push inflation and how some long-term generous contracts companies are signing today may backfire.

Investment Thesis

The Invesco Dynamic Leisure and Entertainment ETF ( PEJ ) follows a rules-based Index of 30 U.S. leisure and entertainment stocks selected based on fundamentals. Quarterly reconstitutions indicate a more active approach, but the strategy has yet to succeed over the long run, which I will demonstrate by comparing PEJ's annual returns against 13 alternatives. However, today's article explains my fundamentals-based reason for upgrading PEJ from a sell to a hold. Current shareholders enjoy a higher margin of safety than before, but substantial inflation-related concerns remain. Therefore, tread carefully, and I look forward to discussing this unique ETF in more detail below.

PEJ Overview

PEJ tracks the Dynamic Leisure & Entertainment Intellidex Index, selecting 30 U.S. leisure and entertainment stocks. Currently, key exposure areas are Movies & Entertainment (28%), Restaurants (24%), Casinos & Gaming (14%), and Hotels, Resorts, & Cruise Lines (11%). These are all consumer-focused industries that require a solid economy to succeed. Invesco offers a full suite of Intellidex Index ETFs that evaluate factors across five categories:

1. Price Momentum
2. Earnings Momentum
3. Quality
4. Management Action
5. Value

Reconstitutions are quarterly, and it's common for portfolio turnover rates to exceed 100%. The result may be a substantially different portfolio each quarter, and fundamental analysis may help determine if it's a worthwhile short-term trade. However, long-term buy-and-hold investors should give weight to PEJ's long-term results. I've compiled PEJ's performance rankings against 13 other Consumer Discretionary ETFs since 2010, and the results could be better. Notice the inconsistency. PEJ routinely ranks at either the top or bottom of the category.

These inconsistent rankings make performance charts challenging to interpret. Consider the same data compiled in the chart below. PEJ lagged the Consumer Discretionary Select Sector SPDR ETF ( XLY ) and the Invesco S&P 500 Equal Weight Consumer Discretionary ETF ( RCD ) by 4.81% and 1.80% per year.

However, you can't readily appreciate that PEJ was one of the top performers in 2010, 2012, 2014, and 2016. Its poor post-pandemic returns overshadow everything. Still, the potential for a turnaround is always there. PEJ is up 14.12% YTD through April, just 0.71% behind XLY, the leading fund.

Finally, PEJ's 0.55% expense ratio is a significant headwind. It's the 9th-most expensive out of 14, and the strategy has yet to prove itself over the long run. Therefore, I don't recommend PEJ as a core holding but will use the remainder of this analysis to discuss its short-term potential.

PEJ Analysis

Sector Exposures and Top Ten Holdings

The following table highlights sector exposures for PEJ, RCD, XLY, the SPDR S&P Retail ETF ( XRT ), and the Invesco DWA Consumer Cyclicals Momentum ETF ( PEZ ). These are all options you might consider if you're looking for substantial Consumer Discretionary exposure.

However, many of PEJ's holdings do not fit nicely into one sector or another. For example, its 37% exposure to the Communication Services sector is 28% to Movies & Entertainment, 7% to Broadcasting, and 2% to Interactive Media & Services. You can't get this mix elsewhere, so Intellidex Indexes provide a solution for investors wanting to focus solely on leisure and entertainment. The following table highlights PEJ's industry exposure differences with the four other ETFs listed above.

As shown, PEJ has no overlap with XRT, which focuses on durable consumer goods. PEZ has about a one-quarter overlap with PEJ but includes stocks in other industries like Specialty Retail and Home Improvement Retail. RCD and XLY are the equal- and market-cap-weighted S&P 500 Consumer Discretionary sector ETFs. They're the most diversified and, in XLY's case, dominated by Amazon ( AMZN ), Tesla ( TSLA ), and Home Depot ( HD ).

PEJ's top ten holdings are below. They include Las Vegas Sands ( LVS ), Booking Holdings ( BKNG ), Yum! Brands ( YUM ), and Live Nation Entertainment ( LYV ). It's reasonably well-balanced for a 30-stock fund. PEJ's smallest holding is Tripadvisor ( TRIP ), with a 1.92% allocation.

Fundamental Analysis

The following table highlights selected fundamental metrics for PEJ's top 25 holdings, totaling 89% of the fund. Summary metrics for XRT, PEZ, RCD, and XLY are in the final rows, and all follow a consistent theme: a high five-year beta, indicating approximately 30% more volatility than the broader market.

Still, PEJ stands out for its estimated growth rates of 18.01% and 21.87% on revenue and EBITDA. In contrast, the Consumer Discretionary ETFs (PEZ, RCD, XLY) are 9-13%, with retail's XRT in the low-single-digits. XRT's poor fundamentals are informative. PEJ avoids retail industries entirely and is outperforming all peers YTD except for XLY.

What's exciting is that high growth rates are across nearly all of PEJ's industries except Broadcasting, to which it has minimal exposure. Compared to XLY, PEJ's growth and valuation combination improved since last year. In May 2022, PEJ traded at a 9.18 discount on forward earnings to XLY and offered 2.02% more sales growth. Today, PEJ trades at a wider 9.92-point discount on forward earnings and offers 5.51% more sales growth. PEJ shareholders today enjoy a higher margin of safety than last year, making the risk-reward proposition more enticing.

Key Risk: Rising Wages

Wage-push inflation is a substantial headwind for the economy. According to the Federal Reserve Bank of Atlanta , the three-month moving average median wage growth rate was 6.4% overall in March 2023. Effectively, these higher labor prices get priced into the cost of goods and services, exacerbating the inflation problem.

Leisure and entertainment companies are at higher risk because their workers are more likely to switch industries. And, according to the figures above, they have every reason to. Job switchers' wage growth was 7.3% in March 2023 compared to 5.9% for job stayers. Furthermore, the leisure and hospitality industry led the median wage growth in March 2023 at 7.0%. Here are the figures for other industries that contribute to the overall 6.4% growth rate:

• Construction and Mining: 5.8%
• Education and Health: 5.9%
• Finance and Business Services: 6.4%
• Manufacturing: 6.8%
• Public Administration: 6.4%
• Trade and Transportation: 6.9%

These businesses are in a tough situation, as they can either agree to pay higher wages that may harm them financially or risk losing valuable employees. The path companies take remains unclear. For example, the union representing Delta Air Lines ( DAL ) successfully negotiated a 34% pay increase over four years for its 15,000 pilots. Union members overwhelmingly supported the deal, worth approximately $7 billion in economic value. However, United Airlines ( UAL ) pilots rejected a 15% increase over 18 months in November 2022 as negotiations continue. Finally, 99% of American Airlines ( AAL ) union members approved a strike mandate on May 1, 2023, even as its CEO stated how the airline is prepared to match Delta's pay increases.

My take is that there's an above-average chance a recession will occur in the next year. If that happens, wage growth will slow, and workers will have less bargaining power. Therefore, waiting it out by not agreeing to substantial multi-year pay increases may be more prudent at the company level. Delta took a different route, and its contract is now the industry template. However, both strategies are fraught with risk. The busy summer season is approaching, and companies need a stable workforce to thrive.

Investment Recommendation

PEJ is a dynamic leisure and entertainment ETF with 30 U.S. stocks based on fundamental metrics. As a result, PEJ looks excellent on paper. My analysis revealed improving fundamentals over the last year compared to XLY, the market-cap-weighted Consumer Discretionary ETF. PEJ's discount on forward earnings widened, and its estimated sales growth rate was firm. This higher margin of safety is why I've upgraded my rating from a sell to a hold. However, I won't issue a buy rating for two reasons:

1. PEJ's long-term returns are inconsistent and, when compounded, worse than cheaper and more passive ETFs like XLY.

2. The risk to the leisure and entertainment industry is high. Wage-push inflation is a severe threat with no winners. There may be a substantial upside to companies that secure employees with generous long-term contracts. However, that may backfire if that cost structure threatens the company's financial position. I don't know the answer, but it's not worth the risk.

If you decide to buy PEJ, please consider the abovementioned inconsistency in returns. PEJ has not performed well in consecutive years since 2015-2016, so if you find yourself sitting on a substantial capital gain shortly, consider taking some profits and buying a long-term winner like XLY instead. Thank you for reading, and I look forward to the discussion in the comments section below.

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