VAW: Materials Dashboard For August (NYSEARCA:VAW)

This monthly article series shows a dashboard with aggregate industry metrics in materials. It is also a review of sector ETFs like the Materials Select Sector SPDR ETF (XLB) and the Vanguard Materials ETF (NYSEARCA: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 last week’s closing. Columns stand for all the data named and defined above.

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* capped for convenience

Value and Quality chart

The next chart plots the Value and Quality Scores by industry (higher is better).

Evolution since last month

The value and quality scores have significantly improved in mining/metals. The value score has deteriorated in chemicals and construction materials.

Momentum

The next chart plots momentum data.

Interpretation

The most attractive sub-sectors are mining/metals and construction materials. Both are undervalued relative to 11-year averages and their quality scores are far above the historical baseline. Chemicals and packaging are slightly overvalued, which may be justified for the latter by a good quality score.

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%, which is a bit lower than XLB (0.12%).

The fund has 117 holdings, but it is quite concentrated: the top 10 companies weigh 46.8% of asset value. The next table shows them with some fundamental ratios. The top stock, Linde plc (LIN), weighs 13.3%. The risk related to other stocks is moderate.

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Ratios from Portfolio123

VAW beats XLB in total return since inception (see next table). However, the difference in annualized return is only 47 bps. It is also slightly more volatile.

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Data calculated with Portfolio123

In summary, VAW is a good product for investors seeking capital-weighted exposure in basic materials. It currently holds 117 stocks including large-, mid-, and small-caps, whereas XLB invests in only 29 large companies. VAW is less concentrated in top holdings: for example, LIN weighs 13.3% vs. 17.3% in XLB. VAW is also cheaper than XLB in management fees, and slightly ahead of it in performance since 2004. However, XLB has much higher trading volumes, which makes it a better instrument for trading and tactical allocation strategies. Investors who are concerned by risks related to the top holding weight may prefer the Invesco S&P 500 Equal Weight Materials ETF (RTM).

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 chemical company with an Earnings Yield above 0.0476 (or price/earnings below 21.00) is in the better half of the industry 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.

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It is a dynamic, monthly list with a statistical bias toward excess returns in the long term, not the result of an analysis of each stock.