2023-11-23 00:51:56 ET
Summary
- As a quality-centered play tracking the worthiest Russell 1000 constituents, JQUA scores excellently against profitability and capital efficiency indicators.
- There is even a growth ingredient, with the weighted-average EPS and revenue growth rates both bolstered by the software and computer services sector.
- But meaningful exposure to value is what is missing in the JQUA portfolio. This is the primary reason for a hold rating.
The JPMorgan U.S. Quality Factor ETF ( JQUA ) is a passively managed investment vehicle representing a basket of the Russell 1000 constituents that score strongly against a set of profitability, quality of earnings, and balance sheet health indicators. My previous note on JQUA was published in January, and an update is certainly necessary as its underlying index has gone through a quarterly review in March, June, and September, which might have resulted in factor exposure changes and thus a rating upgrade or downgrade might be necessary.
In fact, almost everything is excellent about this ETF. As my analysis illustrated, its exposure to the quality factor is solid, partly thanks to the sector mix. Besides, there are even some healthy growth stories beneath the surface, with the weighted-average forward EPS growth rate being especially notable, to be detailed below. Next, JQUA's mix of ETF grades is also strong, with only Dividends being rather soft.
Nevertheless, something is missing. And with this ingredient absent, I cannot upgrade JQUA to a Buy today.
Rock-solid quality in a tech-heavy portfolio
As a refresher, JQUA's investment mandate is to track the JP Morgan US Quality Factor Index. As described in the fund's prospectus :
Holdings in the Underlying Index are selected primarily from the constituents of the Russell 1000 Index, a larger Russell Index, which is comprised of large- and mid-cap equity securities of companies located in the United States. The rules-based proprietary selection process utilizes a quality factor to identify higher quality companies as measured by profitability, quality of earnings, and solvency.
Importantly, the index incorporates an industry neutrality principle (not a sector neutrality principle, since we are talking about an index selecting its components from the Russell 1000), which means JQUA's industry allocations should be mostly similar to those of the iShares Russell 1000 ETF ( IWB ).
The full list of profitability, quality of earnings, and solvency metrics used, as well as the discussion of weighting nuances, can be found in the index methodology document on the LSEG website .
More specifically, as of November 17, JQUA had a portfolio of 255 stocks and REITs representing 11 industries and 39 sectors (ICB taxonomy), with technology (32%; predominantly companies from the software and computer services sector), consumer discretionary (for the most part, travel & leisure and retailers; 14%), and industrials (12.7%) being the major allocations.
There are a few facts that support my point that this portfolio heavy in software companies has rock-solid quality.
- First, even though it has seen a few adjustments and stocks that have been added since my January coverage account for around 10.7% of the net assets at this juncture, the basket is still completely dominated by top-quality names, as illustrated by the share of companies with a B- Seeking Alpha Quant Profitability rating or higher, 96.7%. In January, this figure was only slightly stronger, at 97.8%.
- Moreover, the most interesting part here is that the weight of those in the A (including A+ and A-) league is one of the largest I have seen to date, over 90%.
- JQUA delivers impressively on the cash flow front. There is only one net CFFO-negative company (excluding the financial sector) in this basket, Ubiquiti ( UI ), accounting for about 1 bps of the net assets. At the same time, 96% is allocated to FCF-positive firms.
- Besides, I found out that 44% of the holdings have an FCF margin above the net margin. This is an excellent indicator of their high quality of earnings.
- Next, a stupendous weighted-average Return on Equity of approximately 62.3%, which I arrived at using the data from Seeking Alpha and the fund (holdings' weights only), also supposedly indicates JQUA's attempt to distill a top-quality portfolio was a massive success. As a quick reminder, ROE is among the metrics considered during the constituent selection (in the 'profitability' theme). However, I am not a fan of this metric since it frequently gives a false impression, mostly when a company has a capital structure dominated by debt. In JQUA's case, such a massive ROE is chiefly driven by four companies with four-digit Debt/Equity ratios shown below:
Stock | Weight | ROE | D/E |
Home Depot ( HD ) | 1.36% | 1151.32% | 3444.41% |
Clorox ( CLX ) | 0.26% | 31.58% | 2445.04% |
Colgate-Palmolive ( CL ) | 0.43% | 238.25% | 2148.77% |
Choice Hotels International ( CHH ) | 0.18% | 159.74% | 2078.96% |
Data from Seeking Alpha and the fund
For better context, I have created the following chart showing the ROE and net income margins of the fund's holdings. The log scale is used for the Y axis; negative ROE (2.9% of the net assets, 17 stocks) and missing figures (7% of the net assets, 22 stocks) were removed.
As we can see, there are numerous outliers with a Return on Equity well above 100%, which significantly contributed to the weighted average.
Also, it is worth noting that the WA net margin of the JQUA portfolio is almost 20%, as per my estimates. For context, the Invesco S&P 100 Equal Weight ETF ( EQWL ), a fund capitalizing on U.S. bellwethers, which I have covered just recently with a Buy rating, has an about 16.5% net income margin.
Thankfully, there are other metrics that are not that easy to artificially inflate. A good example is the Return on Total Capital, which is paired with the EBITDA margin in the chart below. 11 companies (only 1.78% weight) with negative ROTC, predominantly from the tech industry, as well as all the financials, were removed; the log scale is again used for the Y axis.
It is clearly seen that most holdings have ROTC above 10%, which I believe is a strong result.
Next, there is even something to appreciate on the growth front, as JQUA sports an 11.5% forward EPS growth rate, as per my calculations; the figure is driven predominantly by the software & computer services sector, including contributions from Snowflake ( SNOW ), NVIDIA ( NVDA ), and Datadog ( DDOG ). The forward revenue growth rate is slightly weaker, though it still looks attractive at 8.3%, thanks to the same sector, but also with notable contributions from travel & leisure, i.e., Live Nation Entertainment ( LYV ), Marriott International ( MAR ), and Expedia ( EXPE ).
What is missing?
It goes without saying that sector mix is one of the essential drives of a fund's factor story. Energy and materials-heavy plays are more attractive from a value standpoint than their IT or health care-heavy counterparts, with exceptions being rather rare. As a fund with overweening exposure to technology, JQUA has somewhat inherited the overvaluation problem from the Russell 1000 index. Apart from the sector mix, another contributor is the size factor. With a weighted-average market cap of $335 billion, it is expectable that the ETF has just a 4.2% earnings yield and 6.8x Price/Sales, as per my calculations. Besides, more than 77% of JQUA's holdings have a D+ Quant Valuation grade or even worse, with 30% being F-rated. This is what makes me feel highly cautious.
Final thoughts
The JPMorgan U.S. Quality Factor ETF offers a solid level of quality along with healthy growth, without any doubt. But this vehicle has a few disadvantages nonetheless, including an overvaluation issue and mixed past performance.
Truly, during the December 2017–October 2023 period, JQUA delivered a much stronger annualized return than the Invesco S&P 500 Quality ETF ( SPHQ ), the iShares MSCI USA Quality Factor ETF ( QUAL ), IWB, as well as the iShares Core S&P 500 ETF ( IVV ).
Portfolio | JQUA | IVV | IWB | SPHQ | QUAL |
Initial Balance | $10,000 | $10,000 | $10,000 | $10,000 | $10,000 |
Final Balance | $18,666 | $17,514 | $17,132 | $17,684 | $17,377 |
CAGR | 11.13% | 9.93% | 9.53% | 10.11% | 9.79% |
Stdev | 16.75% | 17.78% | 18.06% | 17.09% | 18.39% |
Best Year | 28.67% | 31.25% | 31.06% | 33.29% | 33.89% |
Worst Year | -13.46% | -18.16% | -19.19% | -15.77% | -20.49% |
Max. Drawdown | -22.15% | -23.93% | -24.57% | -24.33% | -27.78% |
Sharpe Ratio | 0.61 | 0.52 | 0.5 | 0.55 | 0.5 |
Sortino Ratio | 0.94 | 0.78 | 0.74 | 0.83 | 0.75 |
Market Correlation | 0.97 | 1 | 1 | 0.97 | 0.98 |
Data from Portfolio Visualizer
However, it nonetheless underperformed IVV in 2019-2021, as well as this year.
All in all, this is one of the top low-cost (owing to the 12 bps expense ratio ) vehicles, which I suppose value-agnostic investors should consider in case they are searching for a solution to maximize their exposure to the most profitable and efficient U.S. companies. However, assuming an uncomfortable valuation, I believe a Hold rating is the most appropriate in the current environment.
For further details see:
JQUA: Meaningful Exposure To Value Is Missing