By
Morningstar
:
By Robert Goldsborough
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.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
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