MLI - PSCI: Industrials Dashboard For September

2023-09-15 15:54:29 ET

Summary

• Industrials are the most overvalued sector.
• However, the transportation subsector has attractive value and quality scores.
• Fast facts on PSCI, an alternative or a complement to XLI.
• 10 industrial stocks cheaper than their peers in September 2023.

This monthly article series shows a dashboard with aggregate subsector metrics in industrials. It is also a top-down analysis of sector ETFs like Industrial Select Sector SPDR ETF ( XLI ), 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 subsector : 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 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 transportation in the table below is the 11-year average of the median Earnings Yield in transportation 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). In 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 the last trading day'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 subsector (higher is better).

Evolution since last month

The most notable change is an improvement in valuation for the transportation industry.

Momentum

The next chart plots momentum scores based on median returns.

Interpretation

Industrials are the most overpriced sector in September, as reported in my latest S&P 500 monthly dashboard . However, the transportation industry is undervalued by about 16% relative to 11-year averages, and its quality score is also above the historical baseline. Other subsectors are overvalued by 17% to 43% regarding the same metrics. Overvaluation may be partly justified by a good quality score for services/distribution and building/equipment. However, the latter is the most overvalued subsector.

PSCI fast facts

Invesco S&P SmallCap Industrials ETF ( PSCI ) started investing operations on 04/07/2010 and tracks the S&P SmallCap 600 Capped Industrials Index. It has 95 holdings, an expense ratio of 0.29% and a 12-month distribution yield of 0.83%. Besides the difference in market capitalization of constituents, PSCI also differs from the large-cap fund XLI in industry breakdown. In particular, it overweights machinery (29.6% of asset value vs. 21.7% for XLI) and underweights aerospace/defense (7% vs. 18.4%).

The next table shows the top 10 holdings with fundamental ratios. Their aggregate weight is 25.5% and the largest one weighs about 4%, so the portfolio is well-diversified and risks related to individual companies are moderate. XLI is a bit more concentrated, with over 4% in each of its top 4 holdings.

Ratios by Portfolio123 .

PSCI has outperformed XLI by 17% in total return since inception, but the difference in annualized return is insignificant (33 bps). Moreover, risk-adjusted performance is lower (measured by Sharpe ratio), due to a higher volatility. The correlation between the two funds is high: 0.91.

In summary, PSCI is different from XLI in holdings and industry breakdown, but we can't expect a large difference in long-term performance. Fundamentals of large and small industrial companies are related, either because they are selling similar products and services, or because they are partners in the same supply chains. Nonetheless, both funds may be useful together for investors seeking diversification, and for those implementing a tactical allocation strategy combining relative strength in sectors and size segments.

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 transportation company with an Earnings Yield above 0.0575 (or price/earnings below 17.39) is in the better half of the subsector 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. The list below was sent to subscribers several weeks ago based on data available at this time.

It is a rotational model with a statistical bias toward excess returns on the long term, not the result of an analysis of each stock.

For further details see: