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Valuation Dashboard By Industries: Energy And Materials, October 2015

Summary 4 key fundamental factors are reported across industries in Energy and Basic Materials. They can be used to assess the valuation status of an industry relative to its historical average. They can also be used as a reference for picking quality stocks at a reasonable value. I started in September 2015 a monthly series of articles giving a valuation dashboard by sector of companies in the S&P 500 index (NYSEARCA: SPY ). The idea is to follow up a certain number of fundamental factors for every sector, to compare them to historical averages. This article is the first one of another series going down at industry level in the GICS classification. It covers Energy and Basic Materials. The choice of the fundamental ratios used in this study has been justified here and here . You can find in this article numbers that may be useful in a top-down approach. There is no due diligence, analysis, recommendations, or lists of individual stocks to consider. To make a complete picture by sticking a “bottom-up” under the “top-down”, you have to navigate in articles written by industry experts. Here is the link to articles tagged by sector. Methodology Four industry factors calculated by portfolio123 are extracted from the database: Price/Earnings “P/E”, Price to sales “P/S”, Price to free cash flow “P/FCF”, Return on Equity “ROE”. They are compared with their own historical averages “Avg”. The difference is measured in percentage and named with a prefix “D-” before the factor’s name (for example “D-P/E” for the price/earnings ratio). The methodology is quite different from the S&P 500 dashboard. In some industries, S&P 500 companies are very few, so mid- and small caps are included here. Also, the fundamental industry factors are not median values, but proprietary data by the platform. The calculation aims at eliminating extreme values and size biases, which is necessary when going out of a large cap universe. The drawback is that these factors are not representative of capital-weighted indices. They may be very useful as a reference values for picking stocks in an industry, but are less relevant for ETF investors. Industry valuation table on 10/26/2015 The next table reports the 4 industry factors. For each factor, the next “Avg” column gives its average between January 1999 and October 2015, taken as an arbitrary reference of fair valuation. The next “D-xxx” column is the difference between the historical average and the current value, in percentage. So there are 3 columns relative to P/E, and also 3 for each ratio. P/E Avg D- P/E P/S Avg D- P/S P/FCF Avg D- P/FCF ROE Avg D-ROE Energy Equip. & Services 17.2 24.2 28.93% 0.81 1.73 53.18% 10.58 35.34 70.06% -6.2 7.34 -184.47% Oil/Gas/Fuel 19.65 18.53 -6.04% 2.06 3.35 38.51% 20.11 29.03 30.73% -6.59 4.47 -247.43% Chemicals 19.61 18.48 -6.11% 1.46 1.21 -20.66% 34.93 25.37 -37.68% 8.68 6.74 28.78% Constr. Materials 34.81 21.44 -62.36% 1.33 1.16 -14.66% 65.74 40.5 -62.32% 12.38 5.77 114.56% Packaging 20.11 17.96 -11.97% 0.91 0.61 -49.18% 21.67 20.09 -7.86% 18.77 8.34 125.06% Metals&Mining 21.49 19.83 -8.37% 1.55 2.65 41.51% 16.77 25.53 34.31% -19.32 -8.6 -124.65% Paper&Wood 26.08 21.27 -22.61% 0.75 0.72 -4.17% 20.16 22.81 11.62% 9.09 4.99 82.16% Valuation The following charts give an idea of the current status of Energy and Materials industries relative to their historical average. In all cases, the higher the better. Price/Earnings: Price/Sales: Price/Free Cash Flow: Quality Relative Momentum The next chart compares the price action of the SPDR Select Sector ETF in Materials (NYSEARCA: XLB ) and Energy (NYSEARCA: XLE ) with SPY. (click to enlarge) Conclusion Both sectors are in a downtrend, in absolute and relative to the broad market. At the industry level, Energy Equipment & Services, Oil/Fuel/Gas and Metals/Mining look undervalued relative to their own historical averages for several factors, but they are in negative territory for quality. At the opposite, Chemicals, Construction Materials and Packaging are above their historical average in quality, but overpriced for the 3 valuation factors. No industry in these two sectors looks very attractive. However, comparing individual fundamental factors to the industry factors provided in the table may help find quality stocks at a reasonable price. A list of stocks in energy and basic materials beating their industry factors is provided on this page . If you want to stay informed of my updates on this topic and other articles, click the “Follow” tab at the top of this article. You can choose the “real-time” option if you want to be instantly notified.

Momentum Traps – How To Avoid The Siren Song Of Overhyped Stocks

Faced with choosing between a $10 bottle of wine and a $90 bottle of wine, which would you go for? In one experiment – with the prices of each wine clearly marked – nearly twice as many people preferred the taste of the most expensive bottle. But unknown to the volunteers, the two wines were exactly the same. This test was carried out by American researchers investigating how pricing can influence the brain’s perception of how ‘pleasant’ something is. Told it’s expensive, we tend to like it all the more. It’s an example of what behavioral scientists say is a flaw in human emotions that causes us to be overly-influenced by a good story. The read across for investors could hardly be more stark. Stories in the stock market are like a magnet. With herds of followers, these popular shares typically boast eye-catching price momentum. Yet a good proportion of them hide deteriorating fundamentals and stretched valuations that can be harder to spot (and, for some, easy to ignore). These are the market’s glamour stocks which may well be Momentum Traps – stocks where a sudden change in sentiment could see their momentum crash. Of all the dangers that investors face, perhaps none is more seductive than the siren song of stories. Stories essentially govern the way we think. We will abandon evidence in favour of a good story – James Montier Signs of a Momentum Trap Small cap stocks soared through 2013, and by early the following year some valuations looked frothy. Swept up in a wave of bullish exuberance, popular ‘blue sky’ companies like Blur ( OTC:BLURF ), Monitise ( OTC:MNQQY ) and Cloudbuy ( OTC:CDLBF ) were showing some of the classic signs of being momentum traps. As sentiment towards small caps drifted through the next 12 months, the price of each share was pummelled. The common traits shared by these and other momentum traps was that their strong price momentum hadn’t been matched by improving fundamentals. Yet, they looked expensive and their low QualityRanks pointed to firms that either weren’t profitable at all or were flagging as potentially distressed. Importantly, these were some of the most talked about small caps at the time, promoted by brokers and heavily traded by investors. They were the polar opposite of traditional ‘value’ shares but investors lapped them up all the same. In The Little Book of Behavioural Investing , James Montier of investment firm GMO, says that one of the reasons why people shy away from value investing is that value shares tend to come with poor stories. As a result, they end up being despised rather than admired. He explains: “Which would you rather own? Psychologically, we know you will feel attracted to the admired stocks. Yet the despised stocks are generally a far better investment. They significantly outperform the market as well as the admired stocks.” Indeed, evidence that momentum stocks underperform dates back to a 1993 study by three researchers who made a personal fortune from their findings. Josef Lakonishok, Andrei Shleifer and Robert Vishny showed that investors consistently overestimate future growth rates of glamour stocks relative to value stocks. They said this was because investors typically make judgement errors and extrapolate too much of the past to make predictions about the future. They proved their point by going on to run billions of dollars in their own fund management firm called LSV. Testing the performance of Momentum Traps In Stockopedia’s taxonomy of stock market winners (and losers), Momentum Traps typically have StockRanks that reflect strong momentum but poor value and quality. We can build a screen for these stocks by setting the following filters: Momentum Rank > 80 (i.e. high Momentum) QV Rank < 40 (i.e. poor combined Quality and Value) Market Cap > 100 (i.e. to focus on the more well-known shares) Top 25 stocks by Momentum Rank (i.e. 25 highest Momentum shares in the set) We’ve used the Stockopedia StockRank archives to generate the performance history of a 25 stock portfolio rebalanced annually since April 2013. The results are quite startling (click to enlarge) What happens so often with Momentum Traps is that they outperform the market dramatically… but only for a while. This strong price performance lulls investors into a false sense of security and draws in the suckers right at the wrong time. Most investors buy these stocks at the top, and suffer terrible underperformance when gravity reasserts itself. As we can see, the Momentum Trap portfolio has tracked the FTSE All Share over the last two-and-a-half years but broken everyone’s hearts in the interim. Through 2013, the Momentum Traps portfolio was very much an all-cap affair, with stocks ranging from 3i ( OTCPK:TGOPY ) to Nanoco ( OTC:NNOCF ) and Blinkx ( OTC:BLNKY ). There were (and continue to be) some stocks that held on to the momentum and did well. But in 2014, it was weighted much more heavily towards small caps. It’s here that the trouble starts. As sentiment cooled towards smaller stocks, those that were overstretched paid the heaviest price. Companies like eServGlobal, Quadrise Fuels ( OTC:QDRSF ), Johnston Press ( OTC:JHPSY ) and a handful of resources shares have continued to slide. Dodging a momentum trap bullet Using the above rules on today’s data set, we’ve compiled a list below of stocks that could see their momentum turn if investor sentiment changes. The companies include some popular names like Hutchison China MediTech (Pending: HCM ) and Optimal Payments ( OTCPK:NVAFF ). Note that the ‘buy’, ‘hold’ and ‘sell’ recommendations of the brokers that cover each company are broadly positive in their outlook. Detailed research may uncover nothing to worry about with these shares. However, QV Ranks of below 40 (out of 100) certainly warrants close attention and suggests things could be more precarious than the broker recommendations infer. Name Momentum Rank QV Rank # Buy Recs # Hold Recs # Sell Recs Admiral ( OTCPK:AMIGY ) 98 25 1 10 2 OneSavings Bank ( OTC:OSVBF ) 98 29 – 4 – Hutchison China MediTech 96 14 – – 1 Optimal Payments 95 29 4 – – Grainger ( OTC:GRGTF ) 94 10 3 4 – Severn Trent ( OTCQX:STRNY ) 94 25 2 9 1 NMC Health ( OTC:NMHLY ) 93 20 6 – – Dignity ( OTC:DGNTY ) 92 37 – 4 – To avoid the lure of stories and the risk of succumbing to momentum traps, investors should be alert when strong momentum is paired with deteriorating fundamentals or excessive valuation. Momentum is one of the strongest drivers of returns in the stock market, and certainly capable of carrying story stocks some distance. But momentum can crash, particularly in shares with heady valuations and suspect quality. It’s a message best summed up by Montier, who says the key is to focus on facts. “Focusing on the cold hard facts (soundly based in real numbers) is likely to be the best defence against the siren song of stories.” Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

The Fed’s Delay On Rates Makes SDY A Good Buy

The Federal Reserve has delayed raising rates, giving a boost to dividend funds. Rates are likely to remain at historically low levels well into 2016. SDY is heavily weighted towards the financial sector, providing a nice hedge against any rising rates. The purpose of this article is to evaluate the attractiveness of the SPDR Dividend ETF (NYSEARCA: SDY ) as an investment option. To do so, I will evaluate recent market performance, its unique characteristics, and overall market trends in an attempt to determine where the fund may be headed going into 2016. First, a little about SDY. The fund seeks to closely match the returns and characteristics of the S&P High Yield Dividend Aristocrats Index. This index is designed to measure the performance of the highest dividend-yielding companies in the S&P Composite 1500 Index that have also followed a policy of consistently increasing dividends every year for at least 20 consecutive years. This is unique in that many dividend ETFs focus solely on high-yielding companies while SDY has a focus on high yield, but also a track record of a raising payment. Currently, SDY is trading at $77.04 and pays a quarterly dividend of $.49/share, which translates to an annual yield of 2.54%. Year to date, SDY is down 2.2%, not accounting for dividends, which lags the Dow Jones Index’s return of (1.5%) year to date. However, once dividends are accounted for, SDY has slightly outperformed the Dow for the year. There are a few reasons why I feel SDY is a good buy at current levels. The main reason has to do with the Fed’s unwillingness to raise rates from historically low levels. At the beginning of 2015, investors were fairly confident that rates would rise at some point this year, some believed as early as June. This negatively affected dividend ETFs, as investors had piled into funds such as SDY at record levels in search of a higher yield in a low rate environment. Because of this, SDY, along with similar funds, underperformed the Dow and other investment options. However, as we near the end of the year and an official rate hike has yet to be announced, investors are beginning to buy back into SDY as they realize that the low rate environment is here to stay for a little while longer. This is apparent in SDY’s recent rise, as the fund is up almost 7% in the last month. I believe the ETF will continue to move higher, as investors are continuously pushing back their expectations for a rate hike. According to data compiled by the Chicago Mercantile Exchange, “traders now put just a 7 percent chance of a rate move at Wednesday’s Fed meeting and a 36 percent probability for the final one of the year in December”. Traders now give a 59 percent chance of a rate hike during the March 2016 meeting, almost six months away. If that expectation turns in to a reality, SDY could be a very profitable bet in the short term. A second reason I prefer SDY over other funds has to do with its exposure to the financials sector, at roughly 25% of its total portfolio. Below is a breakdown of the sectors, by weighting, that make up SDY’s holdings : Financials 25.47% Consumer Staples 14.95% Industrials 13.54% Utilities 11.83% Materials 11.15% Consumer Discretionary 7.56% Health Care 5.92% Energy 3.41% Telecommunication Services 3.05% Information Technology 2.88% Unassigned 0.22% As you can see from the chart, financials are the top sector weighting in SDY’s portfolio. I view this as a positive, because it provides the fund with a nice hedge against rising rates, when they do eventually rise. General logic will say that these dividend funds will take a large hit once rates rise, because investors will now be able to command higher yields from less risky assets. However, SDY’s exposure to the financials sector will continue to make this fund attractive as financial companies, such as banks and insurance companies, tend to perform better in a rising rate environment. This occurs for a few reasons. One, banks will typically increase the amount they charge for loans at a faster rate than what they pay for deposits, which widens their spread and overall profit. Additionally, these firms typically have to write-off fewer bad loans, as rates generally rise during a time of economic growth. This means companies are performing better and are more likely to meet their debt obligations, and thus, no default on their loans. Therefore, SDY should experience capital appreciation from this exposure, which would cater to investors who are more concerned with the overall return, (stock price and yield), as opposed to just the yield. Of course, investing in SDY is not without risk. Investors could be wrong and interest rates could rise at a much quicker-than-anticipated pace. If this occurs, the market could move sharply lower, or investors could flee dividend funds. SDY’s yield, at only 2.50%, does not provide much of a cushion if the fund were to move rapidly lower. Additionally, SDY also has a strong weighting towards the US consumer, with weightings of 15% and 8% towards the consumer staples and consumer discretionary sectors, respectively. If the US consumer stops spending, or US job growth weakens, these sectors could be dragged lower and take SDY down with them. However, neither of these scenarios are what I expect to occur. Even if rates do rise, Yellen has made it clear that the increases will be slow and gradual. She does not intend to spook the market, and the past few years have showed investors that the Fed is being extremely cautious with regards to rates. Additionally, consumer spending continues to increase, with a 0.6 percent rise last month (September) according to the Commerce Department. Therefore, I expect SDY to perform strongly despite these headwinds. Bottom line: SDY has had a lackluster year, but has rallied recently as the Fed has delayed raising rates. With this scenario continuing, the fund continues to provide investors with an above-average yield in a low-rate environment. Until rates do rise, dividend ETFs will continue to be profitable for investors. With a fee of only .35% and exposure to the financials sector, which will serve as a hedge when rates do rise, SDY provides investors with a cheap way to profit in the short and long term. Going into 2016, I would encourage investors to take a serious look at this fund.