2023-07-21 07:42:02 ET
Summary
- The industrials sector was expected to perform well due to high-interest rates and Biden's infrastructure policies but has been overshadowed by growth stocks.
- The Vanguard Industrials ETF has seen significant inflows, with its year-to-date net flows reaching approximately $400m.
- Despite its diversified exposure, the underlying fundamentals of VIS's large holdings remain shaky, suggesting other ETFs may offer better returns.
The industrials sector, being a defensive one, was expected to deliver relatively strong performance given the high interest rate environment and weakening macroeconomic backdrop. There are also catalysts from Biden's economic policies which has prioritised infrastructure and industrials spending, or even escalating geopolitical tension which led to more investments in the defence sector - both benefitting the industrials sector. However, it has been shadowed by growth stocks driven by the AI rally, but only lagging to technology, communication services and consumer cyclical sectors with ~10% gain YTD.
Vanguard Industrials Index Fund ETF Shares (VIS) is one of the largest ETF tracking the industrials sector, more specifically the MSCI US Investable Market Industrials 25/50 Index with a diversified range of market caps. Recently, VIS has gained significant inflows which led its YTD net flows to ~$400mn. Hence, it is interesting to dive into VIS to understand more about its investment characteristics and underlying holdings.
The fund is fairly diversified with top 10 holdings taking up ~30% of the total weight, led by RTX , HON , and UPS . It also has good sub-industry diversification with ~16% of the stocks being in aerospace & defense sub-industry.
Performance Review
Comparing VIS YTD performance to some of its peers, it outperformed two other market cap-weighted industrials ETF ( IYJ and XLI ), but lagging the equal weight industrials ETF ( RSPN ) by 2-3%. This signifies the outperformance of size premium (small cap over large cap stocks) within the industrials sector.
Over the longer horizon since January 2021, we can make similar observations where RSPN significantly outperformed with its equal-weight methodology. Meanwhile, VIS has similar cumulative returns to XLI and SPY . From a historical track record standpoint, RSPN may be a better choice with greater returns with similar exposure to the Industrials sector - unless big industrials start to deliver greater returns than the smaller names. One argument for such a thesis may be due to survivorship bias, as the smaller Industrials companies which survived from Covid-era are the ones with strong fundamentals but were temporarily mispriced - which justify the significant outperformance of smaller Industrials companies.
Risk Analytics
VIS has similar volatility as the broad market ((SPY)). The 5Y Bollinger chart below visualizes the price volatility of VIS on a 3-month rolling basis, where it has been trading close to its rolling mean recently with small deviation.
Meanwhile, the rolling Alpha for VIS relative to SPY has been negative across most periods in the year but close to zero lately. Meanwhile, the rolling Beta has been lower than 1 (less sensitive to movements in SPY) but has been getting closer to 1 - which indicates that VIS performance has been mostly tracking the broad market.
Fundamentals Deep Dive
Diving into the underlying fundamentals of VIS, the fund has a weighted-average P/E ratio of 20x which is slightly lower than 23x in SPY, but much higher than the Industrials average of 14x. Across the top holdings, the fundamentals are shaky with big names such as BA and GE having negative earnings, while RTX and ADP also having pretty high P/E.
While return on equity looks decent across the top holdings, most of their revenue growth is on the low end with average EBITDA margins as well. This does not play well with their high valuations, where high expectations could have been priced into the market.
In terms of liquidity, UNP and DE have significant debt to equity ratio (>2), while UNP, BA and ADP have some concerning quick ratio (much lower than <1) - which may indicate potential insolvency.
The market sentiment in overall has been quite mixed, more prominently with RTX, BA, LMT expected to gain while CAT expected to lose. A mixed market sentiment could actually be good for VIS as lower expectations are currently priced in.
Conclusion
In short, VIS delivers decent performance with diversified exposure into the Industrials sector and market beta of ~1 recently. However, RSPN may be a better choice given recent track record of strong outperformance, as the underlying fundamentals of large holdings remain shaky despite potential catalysts.
For further details see:
VIS: Positive Industrials Outlook But Affected By Size Premium