One Intriguing Industrials ETF

Last week brought us a slew of earnings releases and outlooks from some industrial bellwethers like  Caterpillar (CAT),  3M (MMM), and  United Technologies (UTX). With many of the firms beating low expectations by posting better-than-expected margins, the market seemed to take the results in stride. However, outlooks from the companies themselves and macro-level data suggest a mixed picture for industrials in the near term.

From the End of Economic Cliff Diving To�?
With a global economy that is on pace to post the worst yearly production decline in the postwar period, it was no surprise that industrial companies came in with some pretty ugly revenues. Heavy equipment manufacturers Caterpillar,  Terex (TEX), and  CNH Global  reported drops in sales anywhere from 33% to 55%. Other industrial sectors also took some pretty big hits to their top lines. Rail carloads were down about 20%, tonnage levels declined to midteens for the truckers, and  United Parcel Service (UPS) reported average shipments per day of 14.3 million versus 15.0 million in the prior year's quarter.

Though a bottom may be forming, companies were skittish about projecting the timing and breadth of a recovery. The caution expressed by these firms makes sense. The magnitude of the current downturn took many companies by surprise, and current macro-level data isn't encouraging. The Federal Reserve's latest report on industrial production and capacity utilization showed domestic industrial production declining 0.4% in June from May and a year-over-year fall of 13.6%. Capacity utilization stood at 68.0%, down 20 basis points from the prior month. To put this in historical perspective, capacity utilization hit lows of 73.5% and 78.7% in the last two U.S. recessions. Eurozone production did rise somewhat in May but is still down about 17% year over year. Most firms see a weak third quarter followed by better looking numbers in the fourth quarter and into 2010, as annual comparisons ease. To sum up: maybe no significant "green shoots," but probably the end of cliff diving.

Another theme that seemed to be prevalent in company outlooks is the trend in end markets and geographies, indicating the likelihood of choppiness ahead. For example, residential construction appears to be moving in the right direction, but the same cannot be said for nonresidential construction. New-home sales jumped 11% in June, but nonresidential construction looks to continue to decline into next year. The American Institute of Architects thinks that construction spending on offices, retail centers, and hotels is likely to fall 16% this year and 12% in 2010.

From a geographic perspective, in contrast to the Eurozone and the United States, a strong recovery seems to be taking hold in much of developing Asia, fueled by China's massive stimulus package and expansion of credit. Latin America, with the exception of Mexico, also appears to be improving.

Recoveries in emerging markets and bottom formation in developed markets point to a healing in the global markets. But what type of recovery do these companies think we should expect? Here, I would highlight a few comments from conference calls last week. 3M's CEO George Buckley stated: "So, what we see in the shrinking economy is probably not temporary. We think there are few industrial markets that may have been fundamentally reset downwards and perhaps so for many years." From  Illinois Tool Works ' (ITW) CEO David Speer: "At best, we expect minimal end-market recovery in the second half of the year and into next year." The problem seems to be that once inventory restocking is finished, where will the incremental demand come from? Growth is difficult when consumers and financial-services firms continue to delever their respective balance sheets.

To be sure, the magnitude of the downturn may be at play here. Further, it doesn't pay for companies to externally play up the recovery, only to backtrack later if nascent "green shoots" turn to weeds. Emerging-markets recoveries and the impact of fiscal stimuli could improve the demand picture. Even if demand doesn't improve much, the aggressive cost-cutting that enabled many firms to blow away quarterly consensus estimates should bode well for future earnings.

The Economic Cycle and Industrials ETFs
Being in the cyclical names at the right time is very rewarding for investors, as these stocks tend to outperform the broader market. Sector ETFs enable investors to play a recovery without taking on single-stock risk. An investor in an Industrials ETF doesn't care if   FedEx (FDX) is taking market share from UPS as long as industrywide shipping volumes are increasing.

What investors should care about, though, is how the construction of these ETFs can affect how the funds are likely to perform in an upturn, particularly how they perform versus expectations. The three largest industrials ETFs,  Industrial Select Sector SPDR (XLI),  iShares Dow Jones U.S. Industrials Sector Index Fund (IYJ), and  Vanguard Industrials ETF (VIS) are market capitalization weighted. The market-cap weighting affects these funds in two significant ways. First, the ETFs have substantial weightings in a relatively few number of stocks. This is most pronounced in XLI, the big daddy of the industrials ETFs. Nearly half of its assets are in 10 stocks.

The second major implication of market-cap weighting is that the weighting of one stock, in this case  General Electric (GE), can have a huge impact on the fund. Even after the meteoric decline from over $40 to just about $12 today, the company still sports a $130 billion market capitalization, more than 2.5 times that of the next-largest domestic industrials firm. In all three ETFs, GE accounts for more than 10% of net assets. As GE shareholders have painfully realized over the past few years, the conglomerate has its hands in a number of nonindustrial businesses, none more significant than financial services through GE Capital. The credit crisis and subsequent economic downturn have wreaked havoc on GE Capital's financing costs, income streams, and asset values. Longer term, credit conditions and possible changes in regulation are specific risks for financial-services businesses like GE Capital that are not shared by industrial companies. GE also has considerable exposure to health care as well as media and entertainment.

Concentrations in large stocks may not be the only reason these ETFs may not perform as an investors may expect. Aerospace and defense firms comprise anywhere from 19% to 29% of net assets. The aerospace cycle tends to lag the broader industrials cycle because orders for airplanes are made years in advance of delivery and defense spending doesn't necessarily ebb and flow with the economic cycle. In addition, shippers like UPS and  Union Pacific (UNP) do not exhibit the type of leverage to the global economy as, say, a Caterpillar.

My colleague, Scott Burns, recently highlighted his desire to see the industrials space sliced and diced into finer subsectors, like machinery, to offer investors a fund more tightly tethered to the ups and downs of the global economy. For now, IYR, IYJ, and VIS may be best for investors seeking a collection of the highest-quality industrial names. These funds do have a substantial portion of their net assets in companies with economic moats, or firms our equity analysts believe have sustainable competitive advantages.

One Shining Star among Industrials ETFs
While we continue to seek higher beta industrials ETFs, we have uncovered an interesting choice that may be a bit more appealing than the market-cap-weighted ETFs:  PowerShares Dynamic Industrials (PRN). Since its October 2006 inception, PRN has outperformed its ETF peers in both rising and falling markets. Compared with XLI, PRN was up nearly 250 basis points greater in 2007 and lost nearly 250 basis points less in 2008. The outperformance has continued thus far in 2009.

While the absence of GE in PRN's portfolio alone was beneficial to the fund's performance, its success was more a reflection of stock selection and a few other likely factors, such as timeliness (stocks are selected by its underlying index quarterly, utilizing a 25-factor proprietary model). In addition, PRN's risk metrics indicate that it managed to outperform at similar levels of risk. In its short existence, this fund has not only delivered better returns but better risk-adjusted returns.

 

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