Mondayâs Empire State Manufacturing Survey from the Federal Reserve New York Bank showed a third consecutive monthly decline in manufacturing activity in New York. Despite the contraction, however, there are reasons to be optimistic about stocks within the industrial sector.
Reason No. 1? Cash. Corporate cash reserves are at a 55-year high. While much of this cash was built up as a precaution during the recession, low interest rates are not providing a good return on investment. Broad macro concerns aside, there are plenty of arguments for companies to increase their spending on equipmentâdirectly benefiting the industrial companies that make them.
Thatâs especially true given the current tax credit:Companies that invest in new equipment in 2011 can deduct the full value of that purchase immediately, instead of deducting costs slowly over the life of the equipment, as is usually the case. That benefit declines in 2012 to a 50 percent immediate deduction; after 2012, deductions are much slower.
Inventories are also very low compared with where they were over the last decade. Any signs of an economic recovery could lead manufacturing activity to pick up sharply to fill in any inventory gaps.
If you buy into the bullish argument, how do you play it? There are currently eight broad market industrials ETFs to choose from. The first question you should ask when choosing between them is:Do you want a broad market fund or specific market-cap exposure?
For investors wanting broad-based exposure, the Vanguard Industrials ETF (NYSEArca:VIS) is the best choice. The expense ratio is only 0.24 percent, well below the 0.47 percent expense ratio of the iShares Dow Jones U.S. Industrial Sector Fund (NYSEArca:IYJ). VIS also holds 365 companies compared with only 243 in IYJ.
The lowest expense ratio comes from the Industrial Select SPDR Fund (NYSEArca:XLI) at 0.20 percent. The fund invests in the industrial companies in the S&P 500. While the expense ratio is enticing, it only gives exposure to the largest industrial firms in the U.S.âcurrently 62 stocks. The fund offers investors access to what should be the safest industrial firms, and also offers the highest dividend yield, at 2.19 percent.
One risk is concentration:XLI is market-cap weighted and has over 10 percent invested in General Electric ( GE ). One alternative is the Rydex S&P 500 Equal Weight Fund (NYSEArca:RGI). It owns the same large-cap companies as XLI but invests equal amounts in each stock. Currently GE has just a 1.62 percent weighting in RGI. The downside is its expense ratio, which at 0.50 percent, is 2.5 times larger than XLI.
Small-cap companies, while riskier, may benefit the most from an economic recovery. These companies have a harder time finding funding during recessions, but are able to generate higher growth rates during economic expansions. For investors looking strictly for small-cap exposure, there is the PowerShares S&P Small Cap Fund (NYSEArca:PSCI). The fund charges just 0.29 percent in fees, and holds 89 small-cap stocks.
Industrial sector stocks offer investors a way to profit if a double-dip recession never materializes. Any increase in business confidence should translate directly into increased purchases of equipment and higher industrial earnings.
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