FIDU: Industrials Dashboard For January

This monthly article series shows a dashboard with aggregate subsector metrics in industrials. It is also a top-down analysis of sector ETFs like the Industrial Select Sector SPDR ETF (XLI) and the Fidelity MSCI Industrials Index ETF (NYSEARCA:FIDU), 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 subsector: 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 transportation in the table below is the 11-year average of the median Earnings Yield in transportation 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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Value and Quality Chart

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

Evolution Since Last Month

The most notable change is a deterioration of value score in transportation.

Momentum

The next chart plots median returns by subsector.

Interpretation

According to my monthly S&P 500 dashboard, industrials are the second most overvalued GICS sector behind information technology. However, transportation is close to its baseline based on 11-year averages regarding both valuation and quality. Other subsectors are overvalued by 17% to 35% using the same metrics. Overvaluation may be partly justified by a good quality score for building/equipment (which is the most overvalued industry) and to a lesser extent for services/distribution.

Fast Facts on FIDU

Fidelity MSCI Industrials Index ETF (FIDU) has been tracking the MSCI US IMI Industrials 25/25 Index since 10/21/2013. It has a total expense ratio of 0.08%, a bit cheaper than XLI (0.10%).

As of writing, the fund has 389 holdings. The heaviest industries in the portfolio are machinery (20.3% of asset value) and aerospace/defense (15.9%). The next table lists the top 10 holdings with valuation ratios and dividend yields. They represent 27.9% of assets. The heaviest position weighs 3.27%, so risks related to individual stocks are moderate.

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Since inception, FIDU has underperformed XLI by less than 2% in total return (see next table). The difference of 7 bps in annualized return is insignificant. Risk metrics (maximum drawdown and volatility) are almost identical.

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Data calculated with Portfolio123

In summary, FIDU is a fund with cheap management fees for investors looking for capital-weighted exposure in industrials. It has much more holdings than XLI (389 vs. 80), but both funds have almost identical return and risk metrics since 2013. FIDU and XLI are equivalents for buy-and-hold investors. XLI has much higher volumes, making it a better instrument for trading and tactical allocation. Investors looking for a more balanced portfolio may prefer the Invesco S&P 500 Equal Weight Industrials ETF (RSPN), where the top 10 holdings represent only 13.7% of assets and the largest name weighs about 1.4%.

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 transportation company with an Earnings Yield above 0.0428 (or price/earnings below 23.36) is in the better half of the subsector 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 rotational list with a statistical bias toward excess returns on the long-term, not the result of an analysis of each stock.