FMAT: Materials Stocks Could Bounce Into A New Business Cycle (NYSEARCA:FMAT)

Fidelity MSCI Materials Index ETF (NYSEARCA:FMAT) is an exchange-traded fund that provides investors with exposure to small-, mid- and large-cap U.S. stocks that belong to the Materials sector. The fund is based on the MSCI USA IMI Materials Index. FMAT carries a thin net expense ratio of 0.08%, with net assets of $429.8 million as December 31, 2022. The largest holding is 14.20%, Linde plc (LIN), a global multinational chemical company. However, the rest of the fund’s top 10 holdings represent between 3-6% of the portfolio each, and so the concentration is not too excessive.

With the United States heading into a recessionary period next (as anticipated), materials stocks (being largely cyclical, conventionally) have not been the go-to investment strategy.

Nevertheless, equity markets tend to lead the real economy by around 12 months (although they can be quicker or slower to move). With equity markets having fallen through 2022, one may be wise to begin building into positions that stand to perform well into the next business cycle. Materials is one such sector that tends to rebound strongly into new business cycles.

Unfortunately, earnings are cyclical too. FMAT’s index reports trailing and forward price/earnings ratios as of the end of 2022 of 12.57x and 14.88x, respectively, indicating a one-year forward fall in earnings of -15.52%. The return on equity is still high, at 18%, but nominal earnings growth is negative. The price/book ratio was 2.68x, which is relatively modest and certainly helps to support any investment case. Morningstar report an expected earnings growth rate of 12.43% over the next three to five years, but this seems distinctly optimistic to me. Having said that, I would be comfortable with assuming a longer-term bounce-back as follows.

In my investment case, FMAT’s earnings do drop by the forecast -15.52%, yet they then bounce back over the next couple of years, and by year three are approximately what they are on a trailing basis today. The five-year earnings growth average is merely 1.84% per year in my case, less than the headline number I see from Morningstar of 12.43%. Assuming no buybacks, and a constant dividend rate, and earnings multiple, etc., the IRR is over 11%. Take out the effects of the U.S. 10-year yield (“risk-free rate”) and effects of beta, and the underlying ERP is over 6.4%, which is strong and healthy. That suggests both a decent nominal IRR and possibly under-valuation. It also means that if earnings should out-perform expectations, FMAT could perform very well indeed.

Is the price/earnings multiple acceptable? Assuming long-term earnings growth can reach 2%, and a healthy underlying ERP with 5.5%, together with a long-term risk-free rate of 3.50%, the forward price/earnings multiple should be approximately 14.29x. That is approximately what we see now, with a forward multiple of 14.88x. Assuming the 10-year yield drops to 2% over the five years (which is not unreasonable to consider, given longer-term productivity and demographics trends), the longer-term multiple could be as high as 18x. Having said that, keeping the earnings multiple assumption constant makes sense for prudence.

FMAT will likely be an attractive cyclical bet on the global economy, and averaging into positions now through to the end of the year is likely to pay off reasonably well in the longer run. I like the fact that with conservative assumptions, you can see a path forward here for out-performance with earnings growth beating my “pessimistic” (or perhaps more realistic) base case. I would assume suggest, based on historical five-year beta for FMAT of circa 1.17x, that a fair IRR might be in the region of 8-10%. So, in the near term, FMAT could bounce by about 10% just on valuation alone. In summary, I would take a cautiously optimistic view on FMAT for the medium- to long-term.