IYK: Packed With High-Quality Defensive Plays But Comes With Rich Valuation
Summary
- IYK has a top-heavy concentrated portfolio of 54 U.S. consumer staples stocks.
- Its past returns (before end-September 2021) were heavily impacted by growth stocks that the fund no longer holds.
- Its exceptional quality is what appeals to me, but its valuation is a serious concern.
- IYK has an expense ratio over 4x larger than VDC's and XLP's, which makes it a far less appealing long-term holding.
- This time, IYK earns only a Hold rating.
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The shifting tides of market sentiment this year raise the question of whether playing defense makes sense. As tech is reeling on the ropes while the broad market is deeply in the red with the stagflation risk in the mix, exposure to resilient, mostly recession-proof names that can weather persistent inflation and capital scarcity certainly should be considered. Here the consumer staples sector which is deemed as an equity safe haven springs to mind.
Using the ETF screener, I have found a few large and liquid sector-focused exchanged-traded funds including the iShares U.S. Consumer Staples ETF (NYSEARCA:IYK). With a $1.25 billion AUM and an expense ratio of 41 bps, it is in third place after the Consumer Staples Select Sector SPDR ETF (XLP), which is over 13x larger, and Vanguard Consumer Staples ETF (VDC), which has 5x AUM of IYK.
But unfortunately, though betting on consumer defensive names might seem lucrative at the moment, I should warn that exposure to the sector via this investment vehicle has a few downsides.
- First, its past returns were heavily impacted by growth stocks that the fund no longer holds. Hence, its impressive past performance is of little relevance.
- Second, it is rather concentrated, with a pronounced tilt towards grossly overappreciated stocks; the weighting schema is amongst the culprits. Of course, heavyweight defensive plays typically invite premium multiples, especially given profitability characteristics of IYK's holdings are close to perfect, which will be discussed in greater depth below in the note. But between value & quality and expensiveness & quality, I would opt for the former. The latter seems clearly suboptimal for the hawkish cycle that might turn out more aggressive than the market is expecting at the moment.
- And third, IYK has an expense ratio over 4x larger than VDC and XLP, which makes it a far less appealing long-term holding.
Investment strategy: A turnaround in 2021
IYK's returns illustrate vividly how an index change can fundamentally alter the risk and return profile of a passively managed investment vehicle. In September last year, IYK switched to a new underlying index, the Russell 1000 Consumer Staples RIC 22.5/45 Capped Index from the Dow Jones U.S. Consumer Goods Index it used previously; subsequently, known as a Consumer Goods ETF before, IYK became a Consumer Staples ETF.
Though the change might seem minor at first glance, among other things, this meant selling Tesla (TSLA), an EV bellwether that grossly contributed to IYK's returns in the past, especially during the tech rally of 2020 which was backed by the tailwinds spawned by the pandemic. For better context, the holdings dataset from 15 January 2021 I downloaded from the webpage saved by the Wayback Machine shows Tesla accounted for over 20% of the portfolio. Overall, 57 stocks were ousted, including General Motors (GM), Ford (F), Nike (NKE), and Peloton (PTON) while CVS Health (CVS), Corteva (CTVA), and McKesson (MCK) were added, to name a few.
As a consequence, Procter & Gamble (PG), an S&P 500 dividend aristocrat that barely needs a lengthy introduction, moved to the first place from second; at the moment, its weight is slightly north of 16%. Coca-Cola (KO), another dividend aristocrat is now the second-largest investment, with a weight of ~11.3% vs. 6% in January 2021.
That being said, IYK currently has no exposure to the GICS consumer discretionary, communication, financials, and industrial sectors, which combined accounted for 48% of the portfolio in the past. Now, it is over 90% consumer staples, ~7.5% healthcare, and ~2% materials, with CTVA being the only name from that sector.
In this regard, the returns the fund delivered before its recalibration, especially the blockbuster 2020 with a ~32.6% gain vs. IVV's 18.4% and XLP's ~10.2% are of no relevance today.
Remarks on factors: The exorbitant price is paid for quality
The question is, should valuation be ignored when considering defensive plays? Of course not. The recent broad-market sell-off ignited by Target's (TGT) downbeat results has once again illustrated that exposure to richly-valued stocks should be trimmed.
Over 61% of the IYK portfolio has Quant Valuation grades of D+ or worse, principally because the above-mentioned PG, KO, as well as PepsiCo (PEP), IYK's third-largest position with a ~10.6% weight, are all valued at a premium to the sector.
IYK top-twenty stocks as of May 13. Quant data as of May 19
It should be noted that almost a quarter is valued adequately, with multiples mostly below or on par with the sector medians or historical averages, which is manifested in them having a Valuation grade of at least B-. Altria (MO) is among them. However, this can only slightly alleviate risks.
IYK is an around 50% mega-cap mix, with ~3.3% allocation to mid-caps and the rest deployed to large-size stocks. Hence, its valuation profile is barely a coincidence, as higher multiples are inherent to the upper equity echelon, especially considering its solid quality.
More specifically, over 97% of its holdings earned a Profitability rating of B- or higher, and over 82% are A-rated (+/-). To bring more color, the scatter plot below summarizes the EBITDA and FCFE margins for 53 stocks in the basket. Beyond Meat (BYND) was removed intentionally, to improve readability a bit. BYND has ~(122)% FCF and (44)% EBITDA margins.
Created by the author using data from Seeking Alpha and the fund
As you can see, the bulk of the companies is grossly profitable, with copious free cash flows, which should make it easier for them to weather higher interest rates. However, this does not imply it is worth paying a premium at the moment.
IYK and XLP: A quick comparison
Before we proceed to the conclusion, I would like to make a few quick remarks on IYK's peer, the Consumer Staples Select Sector Index-tracking XLP. First, the fund is more concentrated, with 32 holdings vs. IYK's 54. It is long Costco Wholesale (COST), Walmart (WMT), and Estée Lauder (EL), the stocks that are absent in IYK. Meanwhile, it has not invested in CVS, MCK, and CTVA, to name a few. Overall, XLP's holdings have ~85% weight in the iShares ETF. In terms of valuation, the fund has similar issues, with close to 70% of the holdings being relatively overpriced. Quality is even stronger; it does not hold shares in companies with a Profitability rating less than B-.
Final thoughts
IYK is a top-heavy portfolio to express a bullish opinion principally on the consumer staples sector, while also gaining minor exposure to healthcare and materials.
IYK's returns in 2022 to date vividly illustrate that investors have been flocking to defensive plays; even after a swift broad-market sell-off on May 18 triggered by TGT's sluggish results mentioned above, IYK is still ahead of the iShares Core S&P 500 ETF (IVV), and also VDC and XLP. However, the Invesco S&P 500 Pure Value ETF's (RPV) total return is unrivaled anyway.
Of course, in case it was still long TSLA, with a massive allocation, its total return would tell a totally different story.
To sum up, though there is a lot that might appeal to investors, especially its outstanding performance in 2022 so far and close to excellent quality, I emphasize the fund has a few disadvantages, principally in terms of valuation. I am still of the opinion exposure to premium multiples should be kept at a minimum. Ideally, it is best to avoid generously valued stocks right now, regardless of the sector.
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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.