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Valuation Dashboard: Industrials – October 2015

Summary 4 key fundamental factors are reported across industries in the GICS Industrial sector. 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. This article is part of a series 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 and to compare them to historical averages. This article is going down at industry level in the GICS classification. It covers Industrials. 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 analysis of individual stocks. A link to a list of individual stocks to consider is provided at the end. 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 industry factors are proprietary data from the platform. The calculation aims at eliminating extreme values and size biases, which is necessary when going out of a large cap universe. These factors are not representative of capital-weighted indices. They are useful as reference values for picking stocks in an industry, much less for ETF investors. Industry valuation table on 10/29/2015 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 Aerospace&Defense 19.64 18.02 -8.99% 1.15 1.02 -12.75% 22.45 21.28 -5.50% 7.31 9 -18.78% Building Products 27.98 20.14 -38.93% 1.3 0.64 -103.13% 37.43 22.38 -67.25% 11.96 6.07 97.03% Construction&Engineering 19.89 18.3 -8.69% 0.4 0.48 16.67% 15.75 19.81 20.49% 3.86 5.98 -35.45% Elec.Equipment 23.15 18.31 -26.43% 1.53 1.64 6.71% 25.31 21.88 -15.68% -7.83 -3.3 -137.27% Ind. Conglomerates 36.65 20.45 -79.22% 2.44 1.3 -87.69% 29.48 29.98 1.67% 2.59 12.12 -78.63% Machinery 17.84 18.25 2.25% 1.04 0.9 -15.56% 25.17 21.81 -15.41% 10.34 8.72 18.58% Trading Companies&Distri 17 17.14 0.82% 0.58 0.7 17.14% 14.47 25 42.12% 8.39 8.61 -2.56% Commercial Services&Supplies 22.99 20.86 -10.21% 1.22 1.03 -18.45% 26.12 19.84 -31.65% 3.9 3.99 -2.26% Professional Services* 21.91 24.04 8.86% 1.5 1.22 -22.95% 19.53 17.43 -12.05% 6.51 3.09 110.68% AirFreight&Logistics 23.45 21.06 -11.35% 0.65 0.57 -14.04% 23.49 32.87 28.54% 12.44 11.12 11.87% Airlines 12.02 15.18 20.82% 0.96 0.41 -134.15% 24.97 12.37 -101.86% 25.32 3 744.00% Marine** 16.02 14.04 -14.10% 1.13 1.41 19.86% N/A N/A N/A -13.74 6.05 -327.11% Road&Rail 16.71 19.17 12.83% 1.15 0.86 -33.72% 28.74 36.17 20.54% 16.39 9.43 73.81% Transport Infrastructure 7.7 23.6 67.37% 1.07 1.19 10.08% 5.48 20.8 73.65% 16.51 -3.22 612.73% *Professional Services: Avg since 2008 **P/FCF currently outlier for Marine Valuation The following charts give an idea of the current status of 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 (NYSEARCA: XLI ) with SPY. (click to enlarge) Conclusion Industrials have underperformed the broad market in the last 6 months. At the industry level, Transport Infrastucture, Road & Rail are the only 2 industries with at least 2 of 3 valuation ratios pointing to underpricing, and a quality level above their respective historical averages. However, there may be quality stocks at a reasonable price in any industry. To check them out, you can compare individual fundamental factors to the industry factors provided in the table. As an example, a list of stocks in Industrials 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.

Why There Will Never Be Another Warren Buffett

Summary Increasing numbers of highly intelligent people have been drawn to the stock market over the past several decades. As a result, it has become extremely difficult for individual investors to gain an “edge” over the competition. This explains why it’s so hard to produce the kind of “outlier” returns investing legends like Warren Buffett achieved. In an interview in the late 1990s, Warren Buffett famously said that he could “guarantee” 50% annual returns if he was managing less money. He explained that compounding large sums of money at high rates becomes increasingly difficult over time, because it limits the investable universe to only the largest companies. A smaller portfolio would allow him to invest in smaller companies, which have historically produced slightly better returns than their larger counterparts. He further pointed out that today’s easy access to information makes it easier than ever to find such companies selling cheaply. Unfortunately, Buffett’s argument has a major flaw. It’s certainly possible that his performance would improve (marginally) if he was managing millions, rather than billions, of dollars; but to claim that faster access to more information makes it easier to find attractive investment opportunities is illogical. In reality, this actually makes the stock market more efficient (not less), which makes it harder (not easier) to find and exploit pricing inefficiencies. But there’s another equally important factor driving market efficiency: skill. Today’s investors are much better than those of earlier decades, and the difference between the best and the average investor is less pronounced. This is often called the “paradox of skill.” This phenomenon was famously observed by evolutionary biologist Stephen Jay Gould. He wanted to know why no hitter in Major League Baseball has had a batting average over .400 since Ted Williams hit .406 in 1941. He discovered that, while the league batting average has remained roughly the same throughout baseball’s history, the variation around that average has declined steadily. To put that in plain English, it means that skill of modern baseball players is better than ever, which makes outliers like Ted Williams less likely to occur. The paradox of skill is evident in other competitive sports as well. Today’s elite athletes have superior coaching, training, nutrition, and drugs/supplements. Which is why they’re running faster, jumping higher, throwing farther, and lifting heavier than ever before. But as athletes approach the biological limits of human performance, it makes it harder and harder for individuals to stand out from the competition. A perfect example of this is the men’s Olympic marathon. The winning time has dropped by more than 23 minutes from 1932 to 2012; however, the difference between the time for the winner and the man who came in 20th shrunk from 39 minutes to 7.5 minutes over the same period. In other words, the overall skill of Olympic marathoners is improving on an absolute basis but shrinking on a relative basis. We can see the same thing happening in the game of investing. Growing numbers of today’s investors (both retail and institutional) are far more sophisticated and knowledgeable than their predecessors. As a result, just as we’ve seen the disappearance of .400 hitters in baseball, we’re also seeing the disappearance of superstar investors who were once able to persistently outperform the market by large margins. The table below shows that the standard deviation of excess returns (a proxy for investment skill) has trended lower for U.S. large-cap mutual funds over the past several decades. This means that the variation in stock-picking skill has narrowed as everyone got better and the market became more efficient. Decline in Standard Deviation of Excess Returns (Mutual Funds) Note: The table shows the five-year, rolling standard deviation of excess returns for all U.S. large-cap mutual funds. The benchmark index is the S&P 500 (NYSEARCA: SPY ). Source: A North Investments, Credit Suisse (Dan Callahan, CFA and Michael J. Mauboussin) Now consider Buffett’s track record. What do we see? The same exact story as above! During the early part of his career, when the market was underdeveloped and there was less competition, Buffett was the Ted Williams of investing. He had a huge edge over the less-skilled competition. But as more and more intelligent people were drawn to the market over the years, the variation in skill narrowed, shrinking his margin of outperformance. Ironically, even Buffett’s own teacher and mentor, Benjamin Graham, realized that outperforming the market was becoming increasingly difficult over time. In one of his last interviews before he died, he recommended passive (index fund-style) investing and said that it may no longer be possible to identify individual stocks that will outperform. In recent years, Buffett has also become a fan of index funds – not surprising, considering that he’s underperformed the market four out of the last five years. Decline in Standard Deviation of Excess Returns (Warren Buffett) Note: The table shows the five-year, rolling standard deviation of excess returns for Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). The benchmark index is the S&P 500. Source: A North Investments, Berkshire Hathaway 2014 Annual Report The bottom line is that beating the market is becoming tougher, even for the best of the best. If Buffett started investing today with a smaller portfolio, it’s highly unlikely that he would come anywhere near the 50% annualized returns he claims he could get. In fact, over the course of his entire professional career, Buffett only accomplished this amazing feat twice (in 1968 and 1976). It should also be pointed out that even Renaissance Technologies’ legendary Medallion Fund, the most successful hedge fund ever, only managed to deliver annualized returns of 35% (that’s after a 5% management fee and a 44% performance fee). Renaissance employs scores of top PhDs who build elaborate algorithms that identify and profit from various market anomalies. If there really was a simple way to consistently earn 50% annualized returns, they would have found it by now. The reality is, as in baseball, the best hitters in money management can no longer bat .400. It’s extremely difficult to outsmart a market in which so many people have become just as smart as you are.

ETF Issues: What You Don’t Know Might Hurt You

ETFs can be great options for investors. But you have to know what you are buying. iShares, for example, isn’t making that easy, though it’s doing the best it can. Exchange traded funds, or ETFs, are an incredible work of human ingenuity. They are pooled investment vehicles that trade close to net asset value while being traded all day long. And while there are good reasons to like these hot products, there are also reasons to dislike them. And a single data point provided by iShares shows one of those reasons. I don’t hate ETFs To start, I don’t hate ETFs. I just don’t like them as much as most investors seem to. And certainly not as much as Wall Street does, based on how many ETFs have been brought to market in recent years. Yes, they are cheap to own and provide quick and easy diversification. But it’s so easy to buy an ETF that people aren’t looking closely enough at what they are buying. That may not matter much if you pick up the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), a clone of the S&P 500 Index. But with more and more esoteric ETF product being created by rabid Wall Street salesmen, taking the time to get to know what you own is starting to matter more and more. For example, I recently wrote about the fine print in the prospectus of the Global X Yieldco Index ETF (NASDAQ: YLCO ). Essentially, this ETF is focused on buying 20 stocks in a new and niche sector that doesn’t really have 20 stocks to buy. YLCO is all about the story, not so much about the substance, in my eyes. Maybe YLCO will be a great ETF at some point, but right now it’s a risky proposition that all but the most aggressive investors should avoid. So, yes ETFs can be good. But Wall Street has been perverting this goodness in an attempt to make a buck. iShares isn’t evil But don’t think it’s only exotic fare about which you need to be concerned. Even more “normal” stuff can lead you astray. For example, the iShares NASDAQ Biotechnology ETF (NASDAQ: IBB ) has some problems of its own. Now iShares is the ETF arm of giant asset manager BlackRock (NYSE: BLK ). And, for the most part, BlackRock is a stand up company. But that doesn’t mean every product it sells is a good investment option. For example, a quick look at IBB’s overview page shows a P/E ratio of 25. That might not be too surprising given that biotech companies are high growth. You wouldn’t expect a P/E of 10 for this group. In fact, you might even say it’s on the low side for the sector, which is known for housing money losing companies looking for a big score via the creation of new drugs. Which is why you should click the little information icon next to that P/E stat. That’s where you’ll learn that the P/E ratio doesn’t include companies that don’t have earnings. So, essentially, the P/E really tells you less about the ETF’s portfolio than you might at first believe. Interestingly, the same issue pops up throughout iShare’s data on P/E. For example, the iShares U.S. Oil & Gas Exploration & Production ETF (NYSEARCA: IEO ) has a P/E that’s listed at a little over 8. With 70% of its assets in the oil and gas exploration sector, where companies are bleeding red ink, you have to step back and wonder what’s going on. A low P/E makes sense for an out of favor sector, but does that average really tell you the whole story? The thing is the warning about P/E is a standard disclosure on the iShares site and holds true for everything from a niche biotech fund to the company’s S&P 500 Index clone. And iShares really isn’t doing anything malicious. It’s a database issue. You can’t calculate a meaningful P/E if a company doesn’t have any E to work with. So in order to get the job done, in this case calculating an average P/E, you toss the garbage numbers. And, thus, you create a P/E by using only those companies with earnings. Which, unfortunately, biases the number you have just created so that it may offer a misleading picture of the portfolio. So I’m not hating on iShares, there’s not much else it could do to provide site-wide data. And at least it goes the extra step of disclosing this little problem. But it should make you step back and take pause. If you own that biotech fund or the oil and gas fund, the stats you are using to validate your purchase may, in fact, not be reliable. This issue can be found at open-end mutual funds, too, so don’t think ETFs are the only problem child. The best example comes from Morningstar. This research and data house is very open about the way it calculates most of its data, you just have to look. And when it comes to average P/E, they have a workbook available that explains, “If a stock has a negative value for the financial variable (EPS, CPS), the stock will be excluded from the calculation.” EPS is earnings per share and CPS is cash flow per share. So any site that uses Morningstar data will be impacted by this issue… like Fidelity (read the fine print at the bottom of the data page). The question is to what degree is there a problem. In some cases it’s a minor issue. In the case of IBB, roughly half of the ETF’s holding don’t make any money and are excluded from the P/E calculation, according to The Wall Street Journal . That makes the P/E figure provided by iShares pretty much useless in my eyes. And it points out yet another problem that ETF investors may not realize when they buy what is currently a hot Wall Street product. Know what you own For many investors ETFs are seen as a short cut. A punt option that doesn’t require much thinking. In many cases that’s true, but in many others it isn’t. Which is why knowing what you own is so important. Can you accept the average P/E for an S&P 500 Index fund at face value? Yeah, probably. But what about an ETF honed in on an industry that’s filled with money-losing companies, like biotech? I don’t think that passes the sniff test. You’d be better off doing a little more digging into the portfolio to get a good understanding of what’s in there. Again, I don’t hate ETFs. But they are so popular and have been pushed so hard by Wall Street that I fear investors don’t have any clue what they own. Too many people have been lulled into complacency by slick marketing and an avalanche of new products. I don’t think that’s a story that ends well. If you own an ETF, I recommend taking a deeper dive just to make sure you really own what you think you own.