Living in a Materials World

09/08/2010 10:40 am EST

Focus: ETFS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Benjamin Shepherd, associate editor of Personal Finance, says industrial demand is holding up well, and he recommends an ETF for investors to play it.

Although investors rightly fear the wealth destruction that occurs during recessions, the business cycle creates opportunities for those who stay ahead of the curve.

Materials firms benefit from higher industrial demand as the economy begins to pick up steam. Manufacturers purchase these inputs to fulfill the orders that inevitably roll in as businesses restock depleted inventories. This trend has driven US economic growth over the past two quarters.

The ISM Manufacturing Composite Index, another indicator of industrial activity, has dipped since peaking earlier this year, but sill clocks in at 55.5: Readings above 50 indicate that the sector is expanding. July marked the 12th consecutive month of improvement.

A position in Industrial Select Sector SPDR (NYSEArca: XLI) will help investors get ahead of the economic recovery. With $3.8 billion in assets and an expense ratio of just 0.21%, Industrials SPDR is one of the largest and cheapest exchange-traded funds that offer concentrated exposure to the sector. The offering’s closest competitor, Vanguard Industrials (NYSEArca: VIS), charges 0.25% annually and holds $322.6 million in total assets.

Both ETFs track capitalization-weighted indexes, though the number of holdings differs greatly. Whereas Vanguard Industrials allocates its investable assets across roughly 370 names, Industrials SPDR’s portfolio comprises about 50 stocks. The Vanguard fund also holds more small- and micro-cap stocks, which should improve returns over the long term.

But given the economic outlook, Industrial SPDR and its portfolio of large-cap industrials offer superior up side in the near term. Not only do many of the sector’s biggest names benefit from multinational operations and exposure to emerging markets, but their diverse business lines also offset weakness in a particular segment. Many of these companies also boast unassailable competitive positions and pay reliable dividends, providing a defensive edge.

For example, 3M (NYSE: MMM) and General Electric’s (NYSE: GE) products are so ubiquitous that customers would be hard-pressed to avoid their products, while Boeing (NYSE: BA) and Northrop Grumman (NYSE: NOC) benefit from relatively stable demand from militaries worldwide.

And inputs and products wouldn’t circulate efficiently without shipping giant FedEx (NYSE: FDX) and railroad CSX (NYSE: CSX). The fund’s balance between cyclical and noncyclical names provides a bit of resilience—a welcome mix in what promises to be a lumpy recovery.

And if the rebound loses steam, Industrials SPDR will provide investors with an early warning; many of its portfolio holdings sell equipment and supplies to other businesses. If second-quarter earnings are any indication, large-cap industrials continue to benefit as the global economy recovers. Position your portfolio for the next leg of the recovery and buy Industrials SPDR under $33. (It closed Tuesday just below $30—Editor.)

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