VCR: Consumer Discretionary Sector Dashboard For March

This monthly article series shows a dashboard with aggregate subsector metrics in Consumer Discretionary. It is also a top-down analysis of sector ETFs like Consumer Discretionary Select Sector SPDR ETF (XLY) and Vanguard Consumer Discretionary Index Fund ETF Shares (NYSEARCA:VCR), 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 retailing in the table below is the 11-year average of the median Earnings Yield in retail 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. A floor of -100 is set for VS and QS when the calculation goes below this value. It may happen when metrics in a subsector are very bad.

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 subsector (higher is better).

Evolution Since Last Month

Value scores have recently declined in all consumer cyclical industries.

Momentum

The next chart plots momentum scores based on median returns.

Interpretation

The consumer discretionary sector was overvalued by 5.9% relative to 11-year averages when I published my S&P 500 dashboard for March. Durables and apparel, along with consumer services, are undervalued by about 22% relative to their historical baseline. Additionally, the latter has an excellent quality score. Auto and components are moderately undervalued, and the quality score is below the baseline. Retailing is the most overvalued subsector (by 25% relative to the baseline), yet quality metrics are fair.

Focus on VCR

Vanguard Consumer Discretionary ETF (VCR) started investing operations on 01/26/2004 and tracks the MSCI US IMI Consumer Discretionary 25/50 Index. It has 306 holdings and a total expense ratio of 0.10% (XLY is at 0.09%). It is also available as a mutual fund (VCDAX). Fidelity MSCI Consumer Discretionary Index ETF (FDIS) tracks the same index for a marginally cheaper fee (0.08%).

The next table shows the top 10 holdings with fundamental ratios and dividend yields. Their aggregate weight is 57.3%, with 40.5% in the top 3 names. Amazon alone represents almost 23% of the fund’s asset value.

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Ratios by Portfolio123

VCR has outperformed XLY by 45% in total return since 2/1/2004. However, the difference in annualized return is hardly significant: 49 bps. It is also a bit more volatile, and as a consequence the two funds have exactly the same Sharpe ratio (a measure of risk-adjusted performance).

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Data calculated with Portfolio123

In summary, VCR provides capital-weighted exposure to the consumer discretionary sector for a cheap management fee. It holds much more stocks than XLY (currently 306 vs. 54), but it is also very concentrated in the top holdings and it doesn’t make a significant difference in performance since 2004. VCR and XLY are equivalents for long-term investors, but XLY has higher trading volumes, making it a better instrument for short-term trading. Both funds are overweight in Amazon. Investors seeking a balanced portfolio may prefer Invesco S&P 500 Equal Weight Consumer Discretionary ETF (RSPD).

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 retail company with an Earnings Yield above 0.0459 (or price/earnings below 21.79) is in the better half of the industry regarding this metric. A Dashboard List is sent every month with the most profitable companies standing in the better half among their peers regarding the three valuation metrics at the same time. The stocks below are part of the list sent out a few 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 on the long-term, not the result of an analysis of each stock.