2023-06-20 18:00:50 ET
Summary
- Material stocks have seen rising share prices these past few months, outperforming broader equity indexes.
- Earnings have stagnated, and are forecasted to decline in the coming months.
- Higher share prices and declining earnings spell trouble for material stocks moving forward, and for materials funds like VAW.
Author's note: This article was released to CEF/ETF Income Laboratory members on May 14th (all relevant figures have been updated).
I've covered the Vanguard Materials ETF ( VAW ) twice in the past . I've been bullish, due to the fund's cheap valuation, strong growth prospects, and favorable economic conditions. The fund has tended to outperform since, although not significantly so.
VAW's future prospects are materially worse, however, as fundamentals have weakened these past few months. The fund currently trades with a more expensive valuation than average, even as earnings decline, and quite rapidly so. I would not invest in an expensive fund without growth, so I would not be investing in VAW at the present time.
As an aside, since I originally published this article on my investing group, VAW has underperformed, erasing most of its prior outperformance. The fund's issues and risks persist.
VAW - Quick Overview
VAW is a simple materials index ETF, tracking the MSCI US Investable Market Materials 25/50 . It is a relatively simple index, investing in all applicable U.S. materials stock, subject to a basic set of size, liquidity, and other inclusion/exclusion criteria. The materials sector includes companies involved in the production of the following broad product categories:
- Chemicals.
- Construction Materials.
- Containers & Packaging.
- Metals & Mining.
- Paper & Forest Products.
For VAW itself, products are as follows:
VAW
VAW's portfolio is quite diversified, with investments in 114 stocks. The largest of these are as follows:
VAW - Prior Investment Thesis
VAW's investment thesis in prior years rested on the fund's cheap valuation and strong growth prospects.
VAW's valuation was cheap due to investor sentiment. In prior years, think 2020-2021, investors were mostly interested in tech, growth and software, with little interest in more tangible products like steel and mining. VAW focused on the latter, so it traded with a very cheap price and valuation.
VAW's strong growth prospects were due to favorable economic conditions. Demand for manufactured, durable, and finished goods was skyrocketing, due to improved economic conditions following the pandemic, and due to higher tariffs. Demand for the inputs of these goods increased too, which meant materials. Higher demand meant higher sales and prices, significantly increasing industry earnings. Although most industries and companies benefitted from these trends, the impact was particularly pronounced for materials, as these companies are a bit more cyclical, and a bit more attuned to the business cycle.
VAW has outperformed broader U.S. equity indexes since around mid-2020, due to the above. From what I've seen, the shift from growth to value was almost entirely responsible for the fund's outperformance, with the fund mostly matching the performance of U.S. value equity indexes.
VAW - Declining Fundamentals
Growth Analysis
VAW's underlying holdings saw rapid revenue and earnings growth in prior years, due to favorable economic conditions. Growth prospects have materially worsened in the recent months, due to a combination of factors.
Goods production, manufacturing, and construction have declined for months, and stagnated for around a year.
Federal Reserve Bank of St. Louis
Materials are input goods for many of the above, and so we are seeing reduced demand as well. As demand decreases so do prices, with intermediate processed good prices declining by 1.0%, manufacturing material prices declining by 2.4%, and construction material prices down 3.3%. The BLS has a lot of data for these products here , most of which have seen declining prices for months (with lots of volatility and exceptions).
Lower materials demand should lead to lower consumption and sales too, although I've yet to see this reflected in relevant data sources.
As prices and goods sold decrease, so should earnings, with most market analysts expecting industry earnings to decline by 10.5% in the next twelve months. For reference, analysts expect S&P 500 earnings to increase by 3.8%. Bear in mind, that growth figure includes declining earnings in the materials and energy industry, and would be higher otherwise.
JPMorgan Guide to the Markets
Considering the above, it seems that industry earnings have stagnated, and will likely decline moving forward. This is a significant negative for materials companies and funds, including VAW.
Valuation Analysis
VAW's valuation has worsened these past few months, due to rising share prices and declining earnings/earning expectations.
In late 2022, VAW traded with a 12.3x PE ratio, moderately below the industry's 14.8x historical average. Industry valuations were cheap due to a combination of above-average earnings, due to high prices and strong sales, and low share prices, due to equity market losses all throughout the year.
As of today, VAW trades with a 13.7x PE ratio, slightly below historical averages. Industry valuations have worsened due to higher share prices and softening earnings.
Currently, materials trade with a 16.5x forward PE ratio, moderately above industry historical average. Forward valuations are quite weak, as analysts expect significant reductions in earnings in the coming months.
VAW's expensive valuation exposes investors to some risk, and some potential losses. Investors seem willing to pay premium prices for material companies right now , presumably due to long-term bullishness or outlook. The market might always change its mind, especially if economic conditions were to worsen, or if earnings were to decline even further.
As an aside, the energy industry is also seeing declining earnings right now, and that industry trades with a much lower, historically below-average 10.1x PE ratio. There really is no guarantee that investors will continue to reward a declining industry with a premium valuation: they certainly don't do it with energy.
As should be clear from the above, VAW's valuation has steadily worsened these past few months. In my opinion, the fund was a much stronger investment opportunity when it was trading with a cheap valuation than it is today, when it trades with an expensive (forward) one. This seems obvious and self-explanatory, but it's still important to mention.
As a final point, my analysis is dependent on earnings estimates being accurate, which is not a certainty. The economy has performed much better than most analysts expected this year, and it seems that the Fed might be able to engineer a soft landing . Perhaps ongoing economic growth leads to higher-than-expected earnings growth for the materials industry, but I'm just not seeing it in the data right now.
Conclusion
VAW's fundamentals have materially worsened in the past few months, with the fund seeing declining earnings and a more expensive valuation. Under these conditions, I will not be investing in the fund.
For further details see:
VAW: Fairly Valued After Recent Losses