Via SeekingAlpha.com

This article series has been releasing every month since 2015 a dashboard with aggregate sector metrics in the S&P 500 index (VOO, SPY, IVV). This issue is a special one, with a new methodology to calculate more comprehensive Value and Quality Scores. Modifications aim at taking into account outliers and companies with negative earnings, which were ignored in the previous calculations. The new quality score is also more accurate. The period of reference for baseline calculations has also changed. Our top-down articles on sub-sectors will follow the same methodology.

Base Metrics

We calculate the median value of five fundamental ratios in every set (sector or industry): 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 at every weekly closing. 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 become unusable or non available when the “something” is close to zero or negative. With Earnings Yield, companies with no or negative earnings can be taken into account. We use medians rather than averages as aggregate metrics for two reasons. First, medians are more robust to outliers and small sets. Second and most importantly, medians are more useful for stock picking. A median splits a set in two subsets of equal sizes: a good half and a bad half. An average is less relevant as a reference because it may be biased by a few extreme values. In the case of capital-weighted averages, it is also biased by the largest companies. Our metrics are clearly designed with a stock-picking mindset, not for index investing.

Value and Quality Scores

We 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 technology in the table below is the 11-year average of the point-in-time median Earnings Yield of S&P 500 tech companies .

READ ALSO  W.P. Carey: 99% Is No Joke (NYSE:WPC)

We define the Value Score (VS) 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 formulas are below.

VS =100*((EY-EYh)/EYh+(SY-SYh)/SYh+(FY-FYh)/FYh)/3

QS =100*((ROE-ROEh)/ROEh+(GM-GMh)/GMh)/2

The scores are in percentage points (hence the factor 100). VS may be interpreted as the percentage of undervaluation or overvaluation relative to the baseline. A positive score points to undervaluation, a negative one to overvaluation (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.

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, plus two momentum metrics: RetM is the median monthly return and RetY is the median annual return.

VS

QS

EY

SY

FY

ROE

GM

EYh

SYh

FYh

ROEh

GMh

RetM

RetY

All

-18.09

0.03

0.0411

0.4359

0.0281

13.66

47.54

0.0495

0.5397

0.0343

14.48

44.97

13.27%

-0.61%

Cs. Discretionary

-18.27

-0.70

0.0402

0.8682

0.0224

19.35

37.88

0.0519

0.8112

0.0369

20.28

36.71

18.51%

-9.42%

Cs. Staples

-8.50

-5.62

0.0410

0.4558

0.0285

20.18

41.07

0.0491

0.5851

0.0252

22.57

41.36

4.99%

11.25%

Energy

-6.41

-64.67

-0.0011

1.0406

0.0193

0.40

27.95

0.0385

0.5476

-0.0209

7.24

42.94

17.85%

-33.42%

Financials

12.52

10.15

0.0887

0.5505

0.0790

10.39

78.01

0.0639

0.5539

0.0795

9.54

70.08

21.97%

-9.34%

Healthcare

-34.86

6.53

0.0296

0.2434

0.0255

18.04

63.42

0.0436

0.3567

0.0430

16.34

61.80

3.15%

12.26%

Industrials

-14.13

8.25

0.0450

0.5648

0.0318

22.36

37.05

0.0527

0.6942

0.0350

19.44

36.50

16.84%

0.21%

Technology

-30.40

36.35

0.0344

0.2066

0.0301

30.03

65.98

0.0437

0.3402

0.0434

18.23

61.09

11.16%

22.16%

Communication

-8.93

-3.83

0.0551

0.5967

0.0319

14.89

54.69

0.0525

0.6060

0.0457

16.00

55.09

9.84%

-4.64%

Materials

-0.64

-2.85

0.0480

0.7017

0.0267

15.29

34.87

0.0468

0.7289

0.0269

16.16

34.98

17.19%

-1.57%

Utilities

-32.58

9.51

0.0456

0.3833

-0.0712

9.92

43.91

0.0577

0.6869

-0.0438

9.89

36.99

8.16%

-0.42%

Real Estate

-11.30

20.61

0.0342

0.1219

0.0005

7.41

66.80

0.0201

0.1368

0.0073

5.33

65.33

20.48%

-11.41%

READ ALSO  Leaving Las Vegas? Sheldon Adelson Explores $6BN Sale Of Vegas Casinos

(Depending on your screen size, you may need to click on the table then scroll to the right to see all data)

Score charts

The next chart plots the Value and Quality Score in all sectors. For VS and QS like for base metrics, higher is better and negative is bad.

The next chart plots momentum data.

Interpretation

A hypothetical S&P 500 “median” company is overpriced by about 18% relative to average valuation metrics since 2009. Quality is close to the baseline. We can translate median yields in their inverse ratios:

Price/Earnings: 24.3 – Price/Sales: 2.29 – Price/Free Cash Flow: 35.6

The only sector with positive Value and Quality scores is financials. Materials are close to their baseline in value and quality. Consumer goods, industrials and communication are moderately overpriced. Healthcare, technology and utilities are significantly overvalued. It may be justified for technology by an excellent quality score (no claim is made that 1 point of positive quality score offsets 1 point of negative value score).

Energy has an average value score and a very bad quality score. The median earnings yield (EY) and return on equity (ROE) are close to zero. It means about half of S&P 500 companies in this sector are unprofitable regarding these metrics.

All sectors have positive monthly momentum scores, but only three of them have positive annual momentum scores: consumer staples, healthcare and technology.

We use the table above to calculate Value and Quality Scores. It may also be used it in a stock-picking process to check how companies stand among their peers. For example, the SY column tells that a large consumer staples company with a Sales Yield above 0.4558 (or price/sales below 2.19) is in the better half of the sector regarding this metric. A Dashboard List is sent every month to Quantitative Risk & Value subscribers with the most profitable companies standing in the better half among their peers regarding the three valuation metrics at the same time.

READ ALSO  HSBC to revamp business model as lower interest rates hit profit

Most of my stock holdings are based on quantitative value models. However, value is a bad timing indicator. Quantitative Risk & Value (QRV) provides you with a more realistic quantitative approach, for a world of probabilities instead of just risk on/risk off. It includes a systemic risk indicator and strategies based on it. It has not been able to predict Covid-19 black swan, but it sent an alarm signal 2 months before the NBER declared the U.S. are in a recession. Get started with a two-week free trial and see how QRV can improve your investing decisions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.