FIDU: Industrials Offer Potential for Cyclical Returns, But Uncertainty Remains

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Great Warszawski

Fidelity MSCI Industrials Index ETF (NYSEARCH: FIDU) is an exchange-traded fund that offers investors direct exposure to small-, mid-, and large-cap stocks in the US industrial sector. The net expense ratio is low at just 0.08%, while net assets under management were $657 million as of October 31, 2022. FIDU net cash flows over the past year have been negative by around $86 million, which is not surprising since companies in the industrial sector are generally considered cyclical in the market of values.

FIDU ETF Net Funds Flows

ETFDB.com

In recent times, the United States has been enduring higher inflation (which may now be slowing) and lower growth. This is consistent with the later phases of the business cycle, which Loyalty Research confirmed from the fourth quarter of 2022.

Positioning of the US business cycle as of the fourth quarter of 2022

fidelity.com

The FIDU fund tracks its chosen benchmark, the MSCI US IMI Industrials Index 25/50although this is a limited version of the normal US IMI. Industry Index. Currently, the regular version without a lid is not materially different from the version with a lid in its composition. Therefore, I will refer to the normal version, as there is more granular financial data available.

The most recent fact sheet for the FIDU Uncapped Benchmark Index offers post and future P/E ratios of 23.16x and 17.54x, respectively, with a P/B ratio of 4.24x. That implies a future return on equity of 24.17% and a future return on earnings of 5.7%. That’s a modest forward earnings yield, but a decent underlying return on equity. The final dividend yield of 1.58% would imply a dividend distribution rate on earnings of around 37%. All these figures are as of October 31, 2022.

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Assuming a gradual decline in stock returns to around 20%, and otherwise stable returns from stock and dividend payouts, and no buybacks for the time being, my average earnings growth estimate of three to five years into the future reaches 14-18%, which is considerably higher than the 9.51% estimated as of November 10, 2022 of Morning Star.

If I assume buybacks of at least 20% of average net income across the portfolio (plus dividends) and a constant earnings multiple throughout, the average earnings growth potential falls back to around 10-15 %. Keep in mind that given the discrepancy in trailing and forward price/earnings ratios, the market is implying a significant boost in earnings growth from a year ahead, so in any case much of this growth is anticipated.

My basic inputs and assumptions like the ones above lead to an implied IRR of just over 10%. On a beta-adjusted basis, that implies an underlying equity risk premium of 5.42%, or 6.34% without an adjustment for historical volatility.

FIDU ETF IRR Estimate

Author’s calculations

Note that slightly more aggressive buyback programs (on average), a near-term recession delivering disappointing earnings (versus forecasts), and a weaker forward earnings multiple could put pressure on this Yield potential. Industrial companies typically operate in developed, mature and competitive markets, although many also have high barriers to entry. With cyclical momentum, FIDU could outperform, but I think the current valuation does not make industrials the best “cyclical bet” even if this rally comes sometime in the next 9-12 months (eg ). While markets lead the real economy overall, a short and/or mild recession would be required for FIDU to represent an attractive bet today.

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As of October 31, 2022, Fidelity it reports 374 holdings, making the fund well diversified (the top 10 holdings represent between 2% and 4% of the portfolio at most). Although the fund is exposed only to US-listed stocks, this makes the fund’s risk generally lower, as the US is the most developed stock market in the world and therefore enjoys some of the lowest equity risk premiums on average. However, I have already taken all of this into account, and if you imagine a 2% perpetual growth rate and a 4.2% to 5.5% equity risk premium over the long term, the long-term multiple (with a risk-free rate of, say, 4%) would justify a forward P/E multiple of around 13.33-16.13x. Even at the top of the range there, that would imply a -8% drop in the price of the fund alone.

That’s all speculation: Long-term equity risk premiums may converge to much lower rates. Long-term global ERP is closer to 3.2% per teacher job Damodarán (worldwide, taking into account survival bias). Still, I think FIDU will likely remain a bit more volatile than the broader equity indices and offer some opportunity for outperformance, but the risks are still there for underperformance should a cyclical downturn last longer than expected. In short, FIDU is not expensive, but there are probably stronger cyclical bets outside of the industrial sector.

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