With Industrials Firms Lagging in Recent Market Rally, Quality Is on Sale

Over the past three months, large- and mid-cap U.S. stocks have rallied nicely. The large and liquid exchange-traded fund that tracks the S&P 500 Index,  SPDR S&P 500 (SPY), has had a total return of 10.1% over that period, led by significant gains in the energy, financials, and tech sectors. Several sectors have lagged the broad benchmark, and one of those laggards--the industrials sector--now looks compelling, valuationwise.

The best ETF for investing in large- and mid-cap industrials names is  Industrial Select Sector SPDR (XLI), a concentrated, market-capitalization-weighted fund that holds just 60 names. The fund trades at 92% of its fair value at a time when SPY trades at 95% of its fair value. What's more, XLI offers a very high-quality portfolio. Fully 93% of the assets in XLI are invested in firms with economic moats, which Morningstar's equity analysts consider to be durable competitive advantages. XLI has recorded a total return of 8.1% over the past three months, underperforming SPY by fully 200 basis points.

Why have some large industrial companies, such as  United Technologies (UTX),  3M (MMM),  Boeing (BA),  UPS (UPS),  Caterpillar (CAT), and  Honeywell International (HON), lagged in recent periods? The reasons are twofold: uncertainty surrounding overseas demand and questions about future U.S. defense spending. We see both dynamics as relatively short-term in nature. We expect the international picture to sort itself out over the next 12-18 months as China takes a breather from its supercharged growth and policymakers endeavor to straighten out Europe's debt picture. We caution that we don't see Western Europe as a growth area going forward, but we believe that as policymakers clean up the continent's sovereign debt problems, uncertainty will dissipate, and it's likely that firms based there will return to traditional levels of spending and investment. Similarly, in the medium term, we expect China and other emerging markets to continue to be strong sources of growth for many large U.S. industrials companies.

U.S. defense spending remains an open question, at least through the upcoming presidential election. Automatic defense cuts are scheduled to take effect in early 2013 to the tune of some $600 billion over the next 10 years. However, politicians--particularly those located in states whose economies are dependent on defense spending--have been huddling and trying to come up with a way to salvage that spending. Trying to predict what politicians will do--especially before a close presidential election when a lame-duck session of Congress will take place immediately afterward--is no easy task, but we believe that whatever the ultimate outcome, it will remove uncertainty that has been weighing on companies such as Boeing,  General Dynamics (GD), and even United Technologies, all of which have exposure to defense spending. That said, our equity analysts continue to expect overall U.S. defense spending to slow in the coming years, amid high deficits and tax-cut extensions, which have had the effect of forcing the government to make cuts elsewhere. Companies exposed to U.S. defense spending will be best served by trying to boost their overseas revenue as much as possible. (We recognize that for some firms the headwinds from slowing domestic defense spending are insurmountable; a good example is  Northrop Grumman (NOC), which generates 85% of sales from U.S. government agencies including the Department of Defense.)

Investors interested in XLI should consider it as a complementary satellite holding in a diversified portfolio. XLI also has one of the lowest expense ratios of all industrial ETFs and is our pick for investors desiring to add industrials-sector exposure.

Fundamental View
The U.S. industrials sector has resumed its solid, albeit slower, growth, as the U.S. economy has continued to grow, and companies are continuing to make gains in emerging markets. Industrial production continues to increase at a mid-single-digit clip, and leading indicators remain positive. U.S. housing and nonresidential construction both look set to produce positive results throughout 2012. Tempering our enthusiasm are Europe, where debt problems and fragile growth expectations may well be driving manufacturing contraction, and China, where economic activity has been slowing. Overall, Morningstar's equity analysts expect industrial production figures to remain strong, with later-cycle capital spending industries likely to shine as well. If growth continues, we expect in particular to see continued growth from later-cycle capital goods manufacturers such as  Emerson Electric (EMR), Caterpillar, and  Parker Hannifin (PH). In addition, the rebuilding of tsunami-affected parts of Japan could be a modest positive for Caterpillar, which has made inroads in that country in recent years.

The outlook and order books provided by industrial companies can provide insights into the health of the overall economy, as these firms tend to sell equipment, parts, and materials to other companies. At the beginning of the food chain are companies like Emerson Electric, whose automation products are used across a variety of production and manufacturing industries, and 3M, which produces adhesives and other specialty materials used in industries as diverse as automotive and food and beverage. A leading indicator for heavy construction activity would be Caterpillar, which makes engines and large earth-moving equipment. UPS, the world's largest package delivery company, serves as a good indicator for end demand by both businesses and consumers. Rail firms, which carry intermodal traffic, also transport coal and chemicals, whose demand is correlated to economic activity, along with less-cyclical agricultural goods.

While XLI's historical performance suggests that it should function well as a cyclical play, some factors may make XLI's future performance relative to the broader market less predictable. XLI has 24% of its assets in aerospace and defense companies such as Boeing,  Lockheed Martin (LMT), and General Dynamics.

Portfolio Construction
One of nine Select Sector SPDRs, this fund tracks the industrials sector of the S&P 500 Index and holds 60 companies. XLI's holdings are market-cap-weighted, with the top 20 holdings accounting for more than 71% of the total portfolio. The largest subsector weightings are aerospace and defense, industrial conglomerates, and machinery companies, which account for 24%, 22%, and 21% of fund assets, respectively. The top five holdings are General Electric (12% of fund assets), United Technologies (5.5%), UPS (5.3%), 3M (4.8%), and  Union Pacific (UNP) (4.7%).

Note that this fund does not hold any steel or materials companies. Investors looking for that sector exposure can take a look at  Materials Select Sector SPDR (XLB) or  Vanguard Materials ETF (VAW).

Fees
The annual expense ratio is 0.18%, which is the lowest fee for any industrials-sector ETF.

Alternatives
Industrial Select Sector SPDR competes against two very similar funds. One is  iShares Dow Jones U.S. Industrial Sector Index ETF (IYJ), which holds 238 names, and the other is  Vanguard Industrials ETF (VIS), which holds 369. All three ETFs have highly correlated returns. Over the last five years, XLI and VIS have had 100% correlated performance, while XLI and IYJ also have had 100% correlated performance over that interval (during that same time frame, XLI and the S&P 500 posted performance that was 96% correlated). IYJ and VIS have much lower trading volumes relative to XLI, however. IYJ charges an annual fee of 0.47%, while VIS' annual expense ratio is 0.19%.

For investors interested in more-global exposure, one industrial ETF is an attractive option.  IShares S&P Global Industrials Sector Index (EXI) holds both U.S. and international industrial names. EXI charges an expense ratio of 0.48% and splits its domestic and international exposure almost straight down the middle, with U.S. industrial names comprising 51% of the fund's assets.

 

 

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