February Dashboard, And Measuring The Mega-Cap Bias With EQWL

This monthly article series reports sector metrics in the S&P 500 Index (SP500). It is also a top-down review of all funds tracking large cap indexes.

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 in every sector: Earnings Yield (“EY”), Sales Yield (“SY”), Free Cash Flow Yield (“FY”), Return on Equity (“ROE”), Gross Margin (“GM”). All are calculated on trailing 12 months. For all these ratios, higher is better and negative is bad. 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 when the “something” is close to zero or negative (for example, companies with negative earnings). I also calculate two momentum metrics for each group: the median monthly return (RetM) and the median annual return (RetY).

I prefer medians rather than averages because a median splits a set in a good half and a bad half. Capital-weighted averages are skewed by extreme values and the largest companies. As a consequence, these metrics are designed for stock-picking rather than index investing.

Value and Quality Scores

Historical baselines are calculated as the averages on a look-back period of 11 years for all metrics. They are noted respectively EYh, SYh, FYh, ROEh, GMh. For example, the value of EYh for technology in the table below is the 11-year average of the median Earnings Yield of S&P 500 tech companies.

The Value Score “VS” is 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).

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, except in energy and utilities where the Free Cash Flow Yield is ignored to avoid some inconsistencies. VS and QS are capped between -100 and +100 when the calculation goes beyond these values.

Current data

The next table shows the metrics and scores as of writing. Columns stand for all the data defined above.

Click to enlarge

**capped for convenience.

Score charts

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

Score variations since last month:

The next chart plots momentum scores based on median returns by sector.

Interpretation

A hypothetical S&P 500 “median” company is overvalued by about 11% relative to historical averages since 2013. Its quality score is above the historical baseline. We can translate median yields in their inverse ratios:

Price/Earnings: 26.11 – Price/Sales: 2.67 – Price/Free Cash Flow: 40.82

Energy has been constantly showing the highest value and quality scores since February 2022. Real estate and financials are respectively undervalued by about 23% and 10% relative to 11-year averages. They also show good quality scores. The fundamental ratios used to calculate these metrics are not the most relevant in these two sectors, but their evolution in time is meaningful (it is what the scores focus on). Consumer staples, utilities and communication services are very close to their historical baselines in value and quality. Consumer discretionary, healthcare and materials are slightly overvalued. This may be offset for consumer discretionary by a good quality score. Technology and industrials are overvalued by 25% to 30%.

EQWL and the mega-cap bias

The S&P 500 shows a total return of 22.7% in 12 months, whereas the median return of index constituents is only 5.9%, as reported in the table above. It means the capital-weighted index performance has been massively skewed to the upside by mega cap companies over the last 12 months.

The mega-cap bias can be measured by comparing the performance of equal weight indexes, for example the S&P 100 Equal Weight Index and the S&P 500 Equal Weight Index. Invesco S&P 500 Equal Weight ETF (RSP), which tracks the latter, is well-known by investors. Invesco S&P 100 Equal Weight ETF (NYSEARCA:EQWL), is a bit more obscure. EQWL was launched about 3 years after RSP, on 12/01/2006. Its portfolio holds the 100 largest companies of the S&P 500 in equal weight. The net expense ratio is marginally higher than for RSP (0.25% vs. 0.20%).

The next chart compares their price returns over the last 12 months (excluding dividends). It can be interpreted in a simple way: on average, the 100 largest companies of the U.S. stock market have returned about 8% more than the 500 largest companies. In fact, the gap is a bit less than that, because these ETFs are rebalanced quarterly, which was a minor drag for RSP relative to EQWL in the rally of 2023.

7 Stocks cheaper than their peers

We use the table above 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 that a large consumer staples company with an Earnings Yield above 0.043 (or price/earnings below 23.26) is in the better half of the sector regarding this metric. A Dashboard List is sent every month to Quantitative Risk & Value members with the most profitable companies standing in the better half among their peers regarding the three valuation metrics at the same time. The table below is an excerpt of the list of 73 stocks sent to QRV members for the month of February 2024.

Click to enlarge

It is part of a larger rotational model with a statistical bias toward excess returns on the long-term, not the result of individual companies analysis.