PSCI - PSCI: A Value Play In Industrials Do Not Forget About Quality Risks

2023-03-17 07:44:14 ET

Summary

• Investors have their rationale to bet on the hawkish era to end soon as higher rates might push the economy much closer to the brink of a full-scale recession.
• This is insufficient to persuade me of value & quality strategies to retire. And PSCI is an interesting option to play value in mostly mid-cap industrials.
• PSCI has a much more attractive valuation than XLI, though with a few quality issues.
• PSCI outperformed XLI over the period discussed, though failed to beat IVV, which suffered a much steeper loss in 2022.
• Nevertheless, I see a liquidity issue similar to PSCD, as the bid/ask spread is at 35 bps and AUM is ~$75.2 million. I am stopping short of the Buy rating.

The markets are still feeling the ripple effects of U.S. bank runs. Aside from valuations in the financial sector being decimated, one of the consequences is the emerged opinion amongst traders and investors that hawks will soon loosen their grip as too much pressure amid the turmoil in the banking industry would simply push the economy into a full-scale recession, a cataclysmic outcome to be avoided. This opinion manifested itself in yields going down quickly , with traders pricing in rate cuts sooner rather than later. A nice example is the 3-year Treasury rate as shown below; at the same time, the iShares 1-3 Year Treasury Bond ETF ( SHY ) soared.

Of course, the potential return of the accommodative monetary policy in theory should provide a robust backdrop for growth stocks and the like, those that were battered heavily amid this bear market. However, I see little justification for a hypothesis that the value & quality factor duo is to be retired at this point, with capital moved into growth value- and quality-light strategies. Importantly, I strongly believe that the combination of profitability and adequate valuation is probably the best one to weather a recession; a low volatility ingredient might also be added to make this mix even better, but this deserves a separate lengthy discussion I will not delve into today.

One of the options for value investors is the Invesco S&P SmallCap Industrials ETF ( PSCI ), the ETF we will be discussing today, a capped index-based fund targeting industrial players selected from the S&P 600. The industries with the greatest impact on its returns at the moment are machinery (29.3% weight), commercial services & supplies (12.7%), and building products (10%).

The problem with this vehicle is that with attractive valuation characteristics inevitably come quality risks. Also, there is something to dislike on the liquidity side. Let me elaborate on that below.

Pros: valuation and performance

Solid value exposure, with nuances

As of March 14, PSCI held 90 stocks, with the major ten accounting for about 26.6%. My calculations reveal that the weighted-average market cap of this mix stands at ~$2.6 billion, with over 76% allocated to companies with market values above $2 billion, technically in the mid-cap league. Here, a necessary remark is that this is not a PSCI-specific issue as numerous funds that have the S&P 600 as a selection universe for their underlying indices are overweight in mid caps. This is something we have already seen in the case of the Invesco S&P SmallCap Consumer Discretionary ETF ( PSCD ) which I assessed in January, with a Hold rating.

Nevertheless, valuation characteristics of PSCI are still close to excellent despite it not being a pure small-cap play. For instance, as I found out upon closer inspection, its weighted-average earnings yield stands at ~6.9%, which comes with a solid WA EPS forward growth rate of around 19%. As it can be seen on the Industrial Select Sector SPDR Fund ( XLI ) website , the P/E for its underlying index is ~21.3x, which translates into the EY of only 4.7%. An essential remark here is that the sector median is ~6.4% at the moment.

For investors who would riposte here that the P/E ratio is of secondary importance for industrials and EV/EBITDA should be used as a principal multiple, I should note that the WA EV/EBITDA is 11.7x, as per my calculations, and this is on par with the sector median; however, the EBITDA forward growth rate is a bit higher, ~9.8% vs. 9.2% for the sector.

On the negative side, there is still something to criticize here. Even though close to 38% of its holdings have a Quant Valuation grade of B- and better, which is ~5.4x higher compared to XLI, almost the same share of the net assets is allocated to mid-cap industrials priced at a meaningful premium, which in some cases looks hardly justified. One example is 3D Systems Corporation ( DDD ), with its D+ grade (the earnings yield and EV/EBITDA are negative, EV/Sales is ~2.4x) and surprisingly soft growth story manifested in both revenue and EBITDA forecast to contract going forward; however, there is still an interesting EPS improvement story that is supposed to play out over the next 3-5 years, so this is likely the major contributor to its lofty valuation.

Performance: stronger than the larger peer, still lagging IVV

Another advantage of PSCI is its rather strong performance.

Incepted in April 2010, PSCI has delivered decent returns since then. During the May 2010 - February 2023 period, it outperformed its larger peer XLI, with a compound annual growth rate 35 bps higher. The downside to mention is a meaningfully higher standard deviation, which is a perennial problem for funds leveraging small/mid-cap-centered strategies. Another issue is the max drawdown of 35.3%, with the nadir touched during the March 2020 sell-off; at the same time, IVV and XLI suffered losses not as steep during the coronavirus market panic.

Created by the author using data from Portfolio Visualizer

Also, a strange deviation I should flag is that PSCI underperformed XLI last year, during a market regime almost ideal for portfolios heavier in value stocks; at the same time, it beat it for four years in a row, including coronavirus-torn 2020 when investors favored growthier players and in 2021, when cheaper cyclical stocks were in the limelight.

Cons: quality leaves a lot to be desired

The downside of almost all passive strategies chasing smaller stocks is softer quality. This is also the case with PSCI.

Despite the fact that this fund has an adequate weighted-average Return on Equity/Return on Total Capital spread, ~16% vs. ~11.3%, it lags XLI on WA EBITDA margin and Return on Total Capital as shown below.

Calculated by the author using data from Seeking Alpha and the fund

Also, and most importantly, only about 49% of PSCI's holdings have a B- Profitability grade and better. Here, it grossly underperforms XLI, which has over 98% allocated to such names. Obviously, the mega/large-cap ETF would be a superior choice for maximalist quality investors.

Final thoughts

Investors have their rationale to bet on the hawkish era to end soon as higher rates might push the economy much closer to the brink of a full-scale recession. However, this is insufficient to persuade me value & quality strategies are to retire. And PSCI, which tracks the S&P SmallCap 600 Capped Industrials Index, is an interesting option to play value in industrials, without reducing exposure to quality to intolerably low levels. Another advantage is that it outperformed its larger peer XLI over the period discussed above, though failed to beat IVV, which suffered a much steeper loss in 2022.

Importantly, its expense ratio of 29 bps is modest, though certainly not as attractive as XLI's 10 bps . Nevertheless, I see a liquidity issue similar to PSCD, as the bid/ask spread is 35 bps, while AUM is only $75.2 million. So I am stopping short of the Buy rating.

For further details see: