SPHQ: Revisiting The Investment Thesis

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Unlocking Alpha
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Summary

  • Since my previous article, SPHQ has slightly outperformed the market but didn't escape the large selling we experienced in US equities.
  • The portfolio's valuation is cheaper than 6 months ago and the fund is now trading at ~14x earnings, which is appealing given the quality of the constituents.
  • Rising interest rates, higher-than-expected inflation, and the prospect of a recession are the greatest risks to SPHQ in my opinion over the next 12 months.
  • Given the above, I believe investors should expect substantial volatility in the next months.
Dollar Seedling - Growth Concept - Plants On Bills In Increase

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Investment Thesis

In my last article on the Invesco S&P 500 Quality ETF (NYSEARCA:SPHQ), I discussed how the fund was fairly valued given the high ROIC of its constituents, and how SPHQ was a buy-and-hold type of investment. Since then, SPHQ lost ~12.8% vs a loss of ~13.8% for the S&P 500 and has slightly outperformed the market. My views on this fund haven't changed and I still think this is a basket of compounders. That said, there are now new challenges that could be a drag on short-term performance. The main threats for SPHQ come from rising rates, higher than expected inflation, and the possibility of a recession. Given the above-mentioned reasons, I think investors should expect high volatility in the upcoming months and could use it to buy shares at a cheaper price.

What Has Happened Since My Last Article

As a reminder, SPHQ tracks the performance of the S&P 500 Quality Index, which is composed of equities in the S&P 500 index that have the highest quality score. You will find below a recent breakdown of the top 10 holdings and you can read more about the strategy in my previous article.

Invesco S&P 500 Quality ETF

Invesco

I have compared below SPHQ's price performance against the SPDR S&P 500 Trust ETF (SPY) over the last 6 months to assess which one was a better investment. Since my previous article, SPHQ slightly outperformed the S&P 500, but overall, it generated negative returns for shareholders.

 S&P 500 Quality ETF price

Refinitiv Eikon

Despite the disappointing results, investors are not yet giving up on SPHQ. This fund registered positive net flows since early November 2021, which tells me investors haven't capitulated yet and are still buying the dips.

SPHQ daily fund flows

ETF.com

The Market Pullback Provides New Opportunities and Risks

In my previous article on SPHQ, I argued that the fund was fairly valued given its exceptional return on equity and good growth prospects. Back then, it was trading at an average TTM price-to-earnings ratio of 19.82. The recent pullback provides now an opportunity to buy this basket of quality stocks at a lower valuation. The fund is now trading at 14x earnings and less than 2x sales.

S&P 500 Quality ETF value and growth measures

Morningstar

However, back in November 2021 when I first looked at SPHQ, there were a limited number of alternatives other than stocks to put your money in. Since then, US Treasury yields have skyrocketed and are starting to compete with stocks. For instance, the 10-year Treasury yield more than doubled since my previous article on SPHQ. That has profound consequences for long-duration assets such as stocks since investors will now pay a lower valuation multiple in order to get a higher yield.

10-year treasury yield

Refinitiv Eikon

What happened in the bond market over the past months is simply a reaction to higher-than-expected inflation, which is negatively correlated to PE multiples. In other words, PE multiples are generally lower when the CPI is high. If you look at the historical figures, it is possible that the S&P 500 could crash another 20% from today and trade at a multiple of 15x earnings. Therefore, I think it is important to keep in mind the downside risk when buying SPHQ and the fact that you will probably have several occasions where you can buy shares at a lower price than today.

Inflation trends

Crestmont Research

Another risk that comes with inflation is the destruction of consumer sentiment. Consumers are likely to cut back on spending when inflation is as high as today, which has a direct negative impact on the economy.

How are you covering the increase in prices

UBS

This starts to be reflected in the US Chicago PMI numbers, which is a great leading indicator of economic activity. This index is used to measure the level of activity of purchasing managers in the private and public sectors. The index is in a downtrend since Q3 2021, and it's now far from its peak but still above 50, indicating we are not in a booming economy, but rather at a tipping point for economic growth.

US Chicago PMI

Refinitiv Eikon

SPHQ has over 30% of total assets invested in cyclical industries such as financials, industrials, and consumer discretionary which makes it vulnerable to changes in the economy. As a result, I expect volatility to be high in the upcoming months, which should be seen as an opportunity to accumulate shares at a cheaper price.

Key Takeaways

Since my previous article, SPHQ has slightly outperformed the market but didn't escape the large selling we experienced in US equities. As a result, the portfolio's valuation is cheaper than 6 months ago and the fund is now trading at ~14x earnings, which is appealing given the quality of the constituents. However, new challenges have emerged that may be a drag on the strategy's short-term success. Rising interest rates, higher-than-expected inflation, and the prospect of a recession are the greatest risks to SPHQ in my opinion over the next 12 months. Given the above, I believe investors should expect substantial volatility in the next months and should use it to purchase shares at a lower price.

This article was written by

Unlocking Alpha profile picture
741 Followers
About me: Value-oriented investor, seeking low-risk investments with the potential to deliver high returns. I like to analyze commodities, ETFs, and cash-flow positive businesses that have a moat and growth opportunities.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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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