CA - VAW: Materials Dashboard For January

2024-01-17 16:52:37 ET

Summary

• The basic materials sector is overvalued by about 6% based on 11-year averages. Nevertheless, the construction materials industry is undervalued by about 17%.
• The subsector with the worst value score is mining/metals.
• Fast facts on Vanguard Materials Index Fund ETF Shares, a good alternative to Materials Select Sector SPDR® Fund ETF.

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

Shortcut

The next two paragraphs in italic 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 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 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 industry (higher is better).

Evolution Since Last Month

The value score has deteriorated for construction materials and improved for mining/metals.

Momentum

The next chart plots momentum scores based on median returns.

Interpretation

According to my monthly S&P 500 dashboard , the basic materials sector is overvalued by about 6% based on 11-year averages. Nevertheless, the construction materials industry is undervalued by about 17% using the same metrics. Moreover, its quality score is far above the historical baseline. The chemicals and packaging industries are close to the baseline regarding both valuation and quality. The less attractive subsector is mining/metals, with an overvaluation reaching almost 40% relative to the baseline.

Fast Facts on VAW

The Vanguard Materials ETF has been tracking the MSCI US IMI Materials 25/50 Index since 01/26/2004. It has a total expense ratio of 0.10%, the same as XLB. It is also available as a mutual fund, Vanguard Materials Index Fund Inst (VMIAX).

The fund has 116 holdings and is quite concentrated. The top 10 companies, listed in the next table, represent 51.5% of asset value. The top name, Linde Plc, weighs 15.9%. Risks related to other companies are moderate.

Ratios from Portfolio123.

VAW has outperformed XLB in total return since inception. However, the difference in annualized return is only 43 bps, which is hardly significant. The risk measured in drawdown and volatility is similar for both funds, as reported in the next table.

Data calculated with Portfolio123.

In conclusion, Vanguard Materials Index Fund ETF Shares looks attractive for investors seeking capital-weighted exposure in basic materials. Its portfolio holds 116 stocks from large to small caps, whereas XLB invests in only 30 large companies. VAW is a bit less concentrated in the top holdings: in XLB, the top 10 constituents represent 66% of the portfolio value and LIN weighs over 20%. Nevertheless, the difference in annualized return since inception is insignificant. XLB has much higher trading volumes, which makes it a better instrument for trading and tactical allocation. Investors who are concerned by risks related to the top holding would likely prefer Invesco S&P 500® Equal Weight Materials ETF ( RSPM ).

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