IYJ: Industrials Dashboard For February

This monthly article series shows a dashboard with aggregate subsector metrics in industrials. It is also a review of sector ETFs like Industrial Select Sector SPDR ETF (XLI), Fidelity MSCI Industrials Index ETF (FIDU), and iShares U.S. Industrials ETF (BATS:IYJ), whose holdings are used to calculate these metrics.

Shortcut

The next two paragraphs in italics 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 into 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). In 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 writing. 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 subsector (higher is better).

Evolution since last month

The most notable move is a deterioration of quality scores in the aerospace/defense industry.

Momentum

The next chart plots momentum scores based on median returns.

Interpretation

According to my S&P 500 dashboard, industrials were overvalued by about 26% relative to 11-year averages at the beginning of February. It is the second most overvalued sector behind technology. Nevertheless, the transportation industry is close to its historical baseline in valuation and quality. Other subsectors are overvalued by 19% to 35% regarding the same metrics. Overvaluation may be partly justified by a good quality score for building/construction/electric equipment and to a lesser extent for services/distribution. Combining valuation and quality, aerospace/defense is the less attractive subsector: both scores are significantly below the baseline.

Focus on IYJ

iShares U.S. Industrials ETF started investing operations on 6/12/2000 and tracks the Russell 1000 Industrials 40 Act 15/22.5 Daily Capped Index. It has a total expense ratio of 0.40%, significantly more expensive than the sector benchmark XLI (0.09%).

As of writing, the fund has a portfolio of 185 stocks. The top 10 holdings, listed in the next table, represent 34.8% of asset value and the largest position weighs 7.58%. Unexpectedly, the top 3 names are not industrial companies, but two financials (Visa and Mastercard) and a technology company (Accenture).

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After a closer look at the portfolio, the GICS industrial sector represents only 63.2% of assets. The fund is quite heavy in financials (23%) and also includes a number of companies from other sectors: technology (6.4%), materials (5.8%), healthcare (0.8%) and consumer discretionary (0.4%).

Since inception, IYJ has lagged XLI by 70 bps in annualized return. Risk metrics are similar (maximum drawdown and volatility in the table below).

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In summary, IYJ is an odd industrial ETF, as only 63% of its portfolio value is in the industrial sector. Moreover, it is less attractive than XLI regarding several criteria: management fee, historical return, and liquidity. XLI and other “true” industrial ETFs are better suited for investors and traders seeking exposure in this sector. Investors looking for a more balanced portfolio than capital-weighted funds may prefer Invesco S&P 500 Equal Weight Industrials ETF (RSPN).

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 0.0425 (or price/earnings below 23.53) is in the better half of the subsector regarding this metric. A Dashboard List is sent every month to 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 model with a statistical bias toward excess returns in the long term, not the result of an analysis of each stock.