FMAT: Materials Stocks Offer Limited Upside (NYSEARCA:FMAT)

Introduction

Fidelity MSCI Materials Index ETF (NYSEARCA:FMAT) is an exchange-traded fund from Fidelity which invests in accordance with its chosen benchmark, the MSCI USA IMI Materials 25/50 Index. The fund was set up on 21 October 2013, and currently has $524.05 million in assets under management. Meanwhile, the fund carries an expense ratio of 0.08%, which is very affordable and yet unsurprising, as Fidelity is typically a very cost-efficient ETF provider (competing providers such as iShares are much more expensive).

The MSCI 25/50 Indexes are rebalanced quarterly, specifically in February, May, August, and November. FMAT will follow this schedule, albeit minor timing differences might arise as a result of various corporate actions like dividends, mergers, splits, or simply Fidelity’s choice in order to more efficiently track the benchmark.

It just so happens that the uncapped version of FMAT’s benchmark is no different from the capped 25/50 version, and since the former provides us with some data, we can work with that data in assessing FMAT’s portfolio. (As a side note, and for clarity: the 25/50 methodology prevents any position from exceeding 25%, meanwhile the sum of all issuers with weights above 5% cannot exceed 50%.)

Portfolio Characteristics

The uncapped benchmark, as referenced above, reports an indicative dividend yield of 1.66%, with trailing and forward price/earnings ratios of 25.65x and 18.91x, respectively. Further, the price/book ratio was 2.90x, with all these figures being as of August 30, 2024. The figures imply a forward earnings growth rate in year one of 34.65%, and a forward return on equity of 15.34%, which is moderately high.

FMAT’s entire portfolio is represented by companies that fall into the U.S. Materials sector. Having said that, the discrimination is mostly based on listing, not geography, and so the fund’s portfolio is actually fairly exposed internationally. The top 10 holdings represented just over half of the portfolio as of recent, which is a reasonably high level of concentration.

These top 10 companies are representative of FMAT’s broader thematic; they are involved in chemicals, materials, and industrial sectors, with products and services including specialty chemicals, gases, coatings, agricultural solutions, and mining.

Notice that Linde PLC (LIN) is a significant exposure at 16.17%, albeit under the 25% rule noted earlier; this company is a multinational chemical company and the world’s largest industrial gas company by market share and revenue. Linde is primarily engaged in manufacturing and distributing atmospheric gases, including oxygen, nitrogen, argon, rare gases, and process gases. The company sells into sectors such as healthcare, manufacturing, and energy, and has also innovated in the clean energy space, particularly in hydrogen and carbon capture.

Linde PLC, the largest holding, is a leading global industrial gas company that supplies a range of gases and related technologies for various industries, including healthcare, manufacturing, and energy, and is known for its innovation in clean energy solutions like hydrogen and carbon capture.

Valuation

Morningstar report a consensus expectation of long-term earnings growth (over three to five years, on average) of 11.54%. Their own forward estimates of return on equity come to a lower 13% (as compared to the MSCI benchmark). Nevertheless, this will be likely owing to slight methodological differences; directionally, I will work with both data sources to build a basic valuation gauge for the FMAT portfolio at present. The fund also seems to have the benefit of not seeing a significant rebalancing in the near future, which helps to strengthen our perception of value, as it results in less uncertainty.

As a first point, the forward price/earnings ratio of just over 18x is very fair, and a further support in reducing future uncertainty, as sometimes ETFs carry elevated price/earnings ratios which can be difficult to assume will hold. In this case, a terminal price/earnings ratio is very fair, given stable earnings growth assumptions of “near-inflation” rates of growth, and a stable U.S. 10-year yield (risk-free rate).

Holding most other factors constant, such as the dividend rate, and assuming dividends are reinvested, a conservative view of earnings growth (with a return on equity falling to about 12% in year six) renders a headline IRR of about 8.16%.

Bear in mind the current U.S. 10-year yield is about 3.7%, while the beta of FMAT is elevated at 1.28x historically (see bottom-right of chart above). This means that the adjusted equity risk premium for FMAT is indicatively circa 3.52% on these (possibly indeed conservative) assumptions. Still, I think a maturation of the return on equity, directionally speaking, of (minus) three percentage points (from 15.34% to 12.06%, in this case) is fair.

Based on this valuation, I would argue that FMAT is not currently appealing, as to support a margin of safety one would need to assume above-consensus earnings growth over the next few years.

Final Comments

It is worth noting at this stage that the Materials sector is considered generally “cyclical”, meaning that you are likely to see some out-performance potential at key points in the business and investment cycle, and under-performance at other key turning points. At the moment, people generally view the U.S. as approaching a recessionary phase, although markets look ahead by 9-18 months or so.

The chart below shows the ratio between FMAT and SPY (an S&P 500 U.S. equity index tracker, for the broader market) since about 2014. As you can see, FMAT can often out-perform SPY, but has not for extended periods. Most recently, FMAT has been underperforming, and so one could consider the potential for outperformance, perhaps in upward revisions to earnings projections for the underlying portfolio.

However, without a boost to the earnings trajectory (relative to the current consensus), I think that FMAT is currently priced too tightly. There is little-to-no room for error. The forward price/earnings ratio is fair, but the historical beta of the fund reveals to me a more uncertain longer-term picture. While a stable, mature portfolio of businesses might generate non-volatile earnings and deserve a lower price/earnings ratio, for a portfolio like FMAT, one could argue for a lower P/E to capture this risk.

Nevertheless, to play devil’s advocate, let’s raise my earnings expectations materially, to a 3-5 year growth rate of about 15% on average (firmly above the 11% figure cited earlier, as reported by Morningstar). This has the effect of raising the headline IRR to as much as 10.88% with an underlying beta-adjusted ERP of 5.66%. This is just outside the beta-adjusted range of 3.2-5.5% I think is fair for U.S. and mature equity markets, indicating slight under-valuation, but that is to be expected with an above-consensus earnings growth trajectory. Even here, the upside is fairly limited, with a volatility-adjusted IRR of closer to 9% on this basis.

In summary, FMAT is interesting to review, and will almost certainly provide some out-performance potential at some point in the future, but I do not think it is today.