Vanguard Consumer Discretionary ETF: An Expensive ETF Buttressed By A Few Hot Pockets

ETFS

Consumer confidence in an industry can be a very fragile thing.

– Virginia Knower

If you’ve been following my commentary in The Lead-Lag Report and Seeking Alpha, you’ll note that I was bullish on the consumer discretionary segment in early April, a time when people were hesitant to dip their toes in this space. I had written a contrarian bullish piece on XLY – a consumer discretionary ETF which has since moved up by 36% and has outperformed the broader markets during this time. Today I will review XLY’s peer, the Vanguard Consumer Discretionary ETF (VCR), which is much smaller in size (AUM of close to $4 billion vs. XLY’s AUM of $16 billion). On account of its passively managed approach (a combination of full replication and sampling), there’s a tight grip on expenses, with an expense ratio of only 0.1%. The fund tracks the MSCI US Investable Market Index (IMI)/Consumer Discretionary 25/50, an index that includes consumer discretionary stocks across all forms of capitalization.

Consumer confidence is still subdued

Widescale confidence is yet to meaningfully return within the consumer discretionary space; the relatively sturdy performance of this segment since the March lows has been driven by a few select sub-sectors and stocks. Consumer confidence, the bedrock on which discretionary spend is based, is still well below pre-pandemic levels and seems to have plateaued for the last couple of months. Could this be on account of policy inertia with regard to further stimulus, or just an ongoing fear of the pandemic? I’d like to think it’s a bit of both.

Holdings Analysis – By Sub-Segment

Consumer Discretionary – Sub-segment

Weight

Internet & Direct Marketing Retail

31%

Home Improvement Retail

11%

Restaurants

11%

Automobile Manufacturers

6%

Automotive Retail

4%

Apparel Retail

4%

Footwear

4%

Homebuilding

3%

Apparel, Accessories & Luxury Goods

3%

Hotels, Resorts & Cruise Lines

3%

Source: Compiled by the author using data from VCR

VCR offers investors exposure to more than 25 different sub-segments within the consumer discretionary space. I mentioned earlier that within this broad space, it’s only a handful of sub-segments that are seeing strong underlying metrics. Well, the stay-at-home culture and the general trepidation about congregating in spaces have been instrumental in driving through traffic to the internet & direct marketing segment, which accounts for 31% of the fund’s total holdings. In fact, most recently, we saw Q2-20 e-commerce retail sales in the US surge by 32% sequentially. Record low mortgage rates and the increased desire to take refuge in one’s home during the pandemic have led to strong investments in the homebuilding (3% of holdings) and the home improvement space (11%). Conditions in most of the other sub-segments have continued to remain weak, or at best patchy.

For instance, consider the restaurant sector, which accounts for the third-largest share within this ETF; as mentioned in The Lead-Lag report, faltering business prospects have led to bankruptcies in this sub-segment.

This is not limited to the restaurant segment alone; even the broader retail segment has had to contend with a precipitous drop in footfalls that are considerably below the norm. As you’d expect, a dim business landscape has continued to keep employment levels stunted; subdued employment in leisure and hospitality is just one example of what’s been largely prevalent across different sub-segments within consumer discretionary. Even with a vaccine around the corner, a return to normal, with elevated occupancy and footfalls, currently looks some way off.

Holding Analysis – Top 10

Stock

Consumer Discretionary – Sub-segment

Weight

Current Fwd. P/E

5-Yr. Avg. Fwd. P/E

% Premium/(Discount)

AMZN*

Internet & Direct Marketing Retail

23.88%

100x

82x

22%

HD

Home Improvement Retail

7.69%

27x

22x

23%

TSLA*

Autos

4.42%

202x

96x

110%

MCD

Restaurants

3.89%

36x

28x

29%

NKE*

Footwear

3.22%

45x

36x

25%

LOW

Home Improvement Retail

3.12%

22x

18x

20%

SBUX

Restaurants

2.44%

99x

54x

83%

BKNG

Internet & Direct Marketing Retail

1.90%

91x

44x

107%

TGT*

General Merchandise

1.70%

27x

18x

53%

TJX

Apparel Retail

1.67%

133x

57x

133%

Source: Compiled by the author using data from VCR and YCharts (*denotes stocks whose current Fwd. P/E Valuations are at the highest point over the last 5 years)

Despite having exposure to almost 300 stocks, VCR’s top-10 stocks account for more than half the total holdings (54%), and one stock, in particular – Amazon.com Inc. (AMZN) – accounts for almost a fourth of the total holdings. In fact, as highlighted in The Lead-Lag Report, AMZN has been very instrumental in propping up the returns of consumer discretionary ETFs.

The stock currently trades at a whopping 100x forward P/E, a 22% premium to its 5-year average. Evidently, investors think its premium multiple comes from prospects in regions outside the US, as its market share in the U.S. is still quite paltry, at low single digits.

These stratospheric valuations are not limited to AMZN alone, and are, in fact, a recurring theme across the other stocks that make up VCR’s top 10. As you can see from the table above, not a single stock currently trades at a discount to its historical average, and 4 out of the top 10 are currently trading at valuation levels which are at the highest point over the last 5 years.

Risk-Adjusted Return Analysis

Source: Yahoo Finance

As can be gauged from the data in the table above, despite being a fund that follows a passive strategy, the risk profile has increased over the years. Systematic risk – as measured by Beta – that was just a little over 1x on a 10-year basis has averaged 1.33x over the last 3 years. A similar spike can be noted on the standard deviation front. Both these measures are above the category average. Despite the increased systematic risk, VCR has been able to bring home sizeable excess returns over the risk-free rate (as measured by the Treynor ratio), which is well over the category average. That said, on a total risk basis, the elevated standard deviation does weigh heavily, as the Sharpe ratio has fallen below 1 in recent years (it is still higher than the category average), indicative of sub-optimal risk-adjusted returns.

Conclusion

On the charts, VCR has gone somewhat parabolic over the last few months and is currently trading at lifetime highs. For a price-sensitive, value-conscious investor, it would be foolhardy to buy this ETF at this price point, regardless of the underlying momentum in some pockets within consumer discretionary. I have already highlighted how steep the valuations are across the predominant stocks of this ETF, but even on a weighted average P/E ratio basis that considers all the constituents, the ETF currently trades at 30x (forecasted P/E of 33.8x). This is most certainly not cheap. The dividend yield at sub-1% too is not too alluring (4-year average: 1.3%). Tread with caution.

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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.

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