Playing a Rebound in Domestic Discretionary Spending

Even with the recent gains in stocks, we think investors seeing green shoots have two solid options to enhance exposure to a broad-based recovery in consumer names. Both the  Vanguard Consumer Discretionary ETF (VCR) and  Consumer Discretionary Select Sector SPDR (XLY) represent sound satellite holdings that trade at modest discounts to our fair value estimates. The majority of the underlying companies in these funds rely on discretionary spending and are well-positioned to pick up market share and emerge from the downturn relatively stronger than their competitors. In addition, both funds offer low costs and fine liquidity. Despite the compelling characteristics of these ETFs, we would wait for pullback in prices to get to more-compelling valuation levels. After all, the recent rally may turn out to be a head fake and the recovery could be more muted than what is implied by the underlying share prices, in aggregate.

Making the Decision
Before making such a sector bet, having a well-thought-out thesis is critical. Does one foresee the green shoots sprouting into a full-blown consumer-led recovery? An increase in the consumer-spending portion of first-quarter GDP, a possible bottoming out in jobless claims, and some better industrial production data may support such a thesis. On the other hand, perhaps slowing April retail sales, a continued contraction in consumer credit, an increase in the savings rate, and still-depressed housing and auto sectors point to, at best, a modest recovery. Consumer spending may remain depressed for some time.

Oftentimes heading into a recovery, it pays to be invested in cyclical sectors such as consumer discretionary and technology, which tend to outperform the broader market. Consumer discretionary, in particular, is a driving force domestically, accounting for two thirds of U.S. GDP. As such, if there is even a smidgen of the appearance of light ahead in what has been a long, dark tunnel, it makes sense to think about how you can adjust your portfolio to take advantage. Timing is important because stocks tend to take off before we actually see pervasive data that shows a broad economic recovery.

Searching for the Suitable ETF
ETFs offer a great way to play a potential broad-based rally in domestic consumer discretionary stocks. To search for some options, we utilized Morningstar's new ETF Screener. Upon landing on the home page of our screener, we first eliminated all of the default criteria by clicking on the Clear button near the top. We then added our own criteria that conformed to our desired search, by clicking on Add Criteria.

We first narrowed our list down to ETFs heavily weighted in consumer discretionary stocks, according to Global Industry Classification Standards. We selected GICS Weighting % and Consumer Discretionary, and then clicked on Add Criteria. To select the range, enter a value manually. We chose ETFs where these stocks made up at least 75% of their securities, and this screen alone reduced the qualifying ETFs down to 14 from a universe of more than 800. Because we seek funds that primarily benefit from a U.S.-based recovery, we screened for companies with at least an 85% exposure in the U.S. To accomplish this, we selected Regional Exposure % and United States, and then clicked on Add Criteria. Entering a range of  85% left us with 10 ETFs.

Looking at the 10 remaining ETFs, we eyeballed the list to eliminate funds that either seemed too narrowly focused to a particular consumer sector or that would lack sufficient liquidity. We eliminated  iShares Dow Jones US Home Construction (ITB) and  SPDR S&P Homebuilders (XHB) because of their dependence on the housing market, and we eliminated retail-specific ETFs  SPDR S&P Retail (XRT) and  PowerShares Dynamic Retail . Finally, we removed four ETFs that lacked the size to give us comfort that investors would take less on the chin from outsized market events and general liquidity issues. Funds with less than $50 million in net assets got the boot.

We were left with two options: Vanguard Consumer Discretionary ETF and Consumer Discretionary Select Sector SPDR.

Different Strokes for Different Folks
Our top choices sport low fees, solid liquidity, and trade at similar discounts to our estimates of their respective fair values, but differences in their holdings make each suitable for different investors, in our view. Although funds share the same top names, VCR holds nearly five times as many stocks as XLY and is less concentrated in larger companies such as  Home Depot (HD),  Lowe's (LOW),  Walt Disney (DIS), and  Target (TGT).

As we would expect, the greater concentration in smaller stocks gives VCR a slightly higher beta (both are above 1.0). This means that the fund will tend to rise and fall faster relative to the market than XLY. On the other hand, XLY has a greater concentration in wide and narrow moat stocks, or stocks that our equity analysts believe have durable competitive advantages. For investors who tend to be more risk-averse and who seek higher-quality firms, we think XLY would be a good fit. On the other hand, those who want to benefit the most in a cyclical upturn will likely find VCR a better choice.

Valuation Matters
Even a positive view of the direction of consumer spending wouldn't be enough for us to jump into one of these funds. It is just as important to assess how much we are paying. For this task, we can utilize the work of Morningstar's equity analysts. The collections of stocks in these funds are considered undervalued, although not currently at levels less than our Consider Buying prices for both ETFs. This makes intuitive sense with the S&P 500 nearly 40% above its March lows. We would certainly keep these funds on the radar screen but seek an entry point that gives us a larger margin of safety. Even if we are in an upward trend, markets don't move in a straight line.

  

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