XLY: Consumer Discretionary Ready To Fly (NYSEARCA:XLY)

Investment Thesis

The Consumer Discretionary Select Sector SPDR Fund (NYSEARCA:XLY) is a buy today because its constituents have excellent earnings momentum and strong profitability. Furthermore, we’ve potentially entered a market environment where metrics like XLY’s high 24.18x forward earnings valuation are less problematic. While you may find it prudent to wait for confirmation of a sentiment change by analyzing next quarter’s earnings results, the potential rewards of buying XLY beforehand outweigh the risks, and I look forward to explaining why in further detail below.

XLY Overview

Strategy and Top Holdings

XLY tracks the Consumer Discretionary Select Sector Index, representing S&P 500 companies operating in industries including retail, hotels, restaurants, and apparel. XLY is the largest Consumer Discretionary ETF with $13.7 billion in assets under management, and it’s also one of the lowest-cost funds with a 0.10% expense ratio. Vanguard’s VCR and Fidelity’s FDIS are other options with similar compositions.

XLY’s top ten holdings are below, with Amazon (AMZN), Home Depot (HD), and Tesla (TSLA) totaling 54.82%. Given this concentration, investors may decide to own the first few from this list. However, not all constituents have a great combination of profitability and earnings momentum. Investors potentially are better off overweighting stocks like McDonald’s (MCD) and General Motors (GM) in anticipation of another solid earnings beat.

Performance History

XLY has generally outperformed the market since its December 1998 launch. Through January 13, 2023, its annualized gain was 8.46% vs. 6.90% for SPY, but given the lengthy history, it’s more helpful to look at rolling returns instead. Portfolio Visualizer provides the following table.

Consider these roll periods as your approximate time horizon. It’s noteworthy how XLY’s average returns exceed 10% for all periods compared to 7-8% for SPY. Meanwhile, if you examine the “high” and “low” results, you’ll notice that the upside potential always outweighs the downside risk. For example, on the five-year period, XLY’s highest annual returns were 9.89% better than SPY’s (32.75% vs. 22.86%), but its lowest returns were only 3.71% worse (-10.38% vs. -6.67%). It’s not to say XLY is a slam-dunk investment if you hold it long enough, but the odds of outperforming seem to increase if you take a buy-and-hold approach. It helps that XLY’s five-year rolling returns dipped below SPY’s in November and now lag by 2.70% (6.63% vs. 9.93%). Fundamentals aside, this graph indicates a buying opportunity.

XLY isn’t the only Consumer Discretionary ETF available. Consider the historical returns for these 13 ETFs in the table below as of December 2022.

Not all are broad-based ETFs. Some, like PBS, BEDZ, and EATZ, are industry-specific and have higher expense ratios. However, XLY has the second-best 208.13% ten-year returns, about 19% behind the Vanguard Consumer Discretionary ETF (VCR). VCR has a larger stock universe and includes some small- and mid-cap companies. This strategy paid off in 2022 as mega-cap stocks tumbled. For instance, the Invesco S&P 500 Equal Weight Consumer Discretionary ETF (RCD) outperformed XLY by 8%.

Fundamental Analysis

Consumer Discretionary vs. Other S&P 500 Sectors

Like any security, XLY has both strengths and weaknesses. My view is that the positives outweigh the negatives, but here is an overview of how XLY compares against nine other S&P 500 sector ETFs (excluding Real Estate) so you can better understand the opportunity.

The Consumer Discretionary sector is risky because it’s highly volatile and has a problematic valuation. In addition, top holdings like Amazon and Tesla missed sales expectations last quarter, contributing to a poor 0.83% sales surprise for the sector. However, XLY scores near the top on estimated sales, EBITDA, and EPS growth. Its constituents have positive price momentum using short- and long-term moving average indicators. And finally, sentiment on Wall Street has turned around. Its 6.33/10 EPS Revision Score, derived from individual Factor Grades provided by Seeking Alpha, is third-best behind Utilities (6.34/10) and Energy (6.45/10). That’s the bull case and why it’s worth overweighting the sector heading into earnings season.

XLY Snapshot: Top 25 Holdings

The following table highlights selected fundamental metrics for XLY’s top 25 holdings. I’ve included the fund’s summary metrics at the bottom alongside VCR, RCD, and the Invesco S&P SmallCap Consumer Discretionary ETF (PSCD), as these were also top performers over the last decade.

Amazon is XLY’s problem child, as few of its metrics are favorable. Analysts estimate 13-14% revenue and EBITDA over the next year, below the fund’s 18.35% average and the 14.60% equal-weight average represented by RCD. Estimated earnings are expected to fall by 8.43%, the company has negative free cash flow margins, and the 4.62 EPS Revision Score translates to a “C” Grade. To understand why, consider how consensus earnings estimates are trending over the last one, three, and six months.

Furthermore, Amazon missed quarterly sales estimates in five of the last six quarters. It’s a sharp reversal from the 9.22% sales beat in Q2 2020, and this lack of performance has contributed to the stock’s unremarkable 2.38% gain in 2021, followed by a massive 49.62% loss in 2022.

Earnings Season Preview

There’s little large-cap investors can do about Amazon’s significant weighting other than skimming the Index or opting for an ETF like RCD. Unfortunately, this route results in a lower-quality portfolio with less growth potential and worse earnings momentum. It’s this last metric I want to focus on because if some of these top holdings reverse the trend with a strong earnings season, XLY will substantially outperform the market. Let’s look at what’s in store for these companies over the next couple of months.

Tesla is first to report on January 25, with analysts expecting $1.14 EPS, or 34.31% year-over-year growth. The subsequent four quarterly consensus growth figures are 7.83%, 41.50%, 14.10%, and 17.90%, so it’s softer than usual. I’m not a Musk fan or a Tesla bull, but I’ve learned not to underestimate the hype he’s capable of generating. A strong earnings beat would be helpful for Consumer Discretionary and speculative stocks overall.

Home Depot and Lowe’s (LOW) will report at the end of February, and although both are down 15% over the last year, they still enjoy strong EPS Revision Grades of “A-” and “A+.” Furthermore, the latest Housing Market Index reading indicates there are reasons for optimism. The Index, which measures homebuilder confidence on a scale from 1-100, was 35 for January on expectations of 31.

Finally, McDonald’s is showing some nice price momentum, up approximately 20% since October 1, 2022. Baird Equity Research reported a 21% three-year increase in QSR same-store sales, primarily due to favorable comparisons as COVID-19 restrictions ease.

Shares were slightly up last year, and McDonald’s is one of the more recession-proof Consumer Discretionary stocks you can own. As illustrated below, its drawdowns were 15% or less except during the early 2000s and the Q1 2020 pandemic crash.

Investment Recommendation

XLY’s constituents are highly profitable, have excellent growth potential, and have terrific earnings momentum, as indicated by its above-average EPS Revision Score. It’s third-best compared to other S&P 500 sector ETFs and suggests a possible shift in sentiment that favors riskier stocks. Historically, XLY outperforms the market, and since its five-year rolling returns slipped below SPY in November, there are technical reasons to buy XLY, too. Therefore, with the earnings season set to begin in just a couple of weeks, it’s worth taking a position. The best-case scenario is that you’ll pick up some quick gains if earnings surprises are bigger than before. The worst case is that they aren’t, and you’ll need to hold onto it for a few years to make your money back. I’m comfortable with either scenario, and I look forward to discussing this strategy and others in the comments section below.