Finding Shelter in Staples

10/27/2008 10:36 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

W. Scott Burns, director of Morningstar’s exchange traded securities analysis, and analyst John Gabriel find an ETF that delivers the bare necessities.

Investors seeking shelter from the crisis of confidence in capital markets may consider Consumer Staples Select Sector SPDR (Amex: XLP).

This exchange traded fund (ETF), which offers exposure to the megacap household names that consumers continue to purchase regardless of the economic climate, could be viewed as a defensive tilt for a broad-based equity portfolio.

Investors looking for explosive growth are better suited going elsewhere, because this portfolio is chock-full of mature businesses offering relatively stable returns and an average market capitalization of about $60 billion.

The fund invests in the consumer-staples stocks of the Standard & Poor’s 500 index and employs a capitalization-weighted structure. Sticking to S&P 500 companies provides an initial screen for quality, as holdings must meet the standards of S&P’s selection committee. In fact, more than 65% of this ETF’s portfolio is invested in “wide moat” firms (with substantial competitive advantage—Editor), and about 25% is allocated to firms that our equity analysts deem as having narrow economic moats.

While investors shouldn’t expect much higher than mid-single-digit top-line growth from these mature firms, the fund does offer a decent dividend yield. The capitalization-weighted structure of this ETF translates into relatively concentrated exposure to a few noncyclical consumer-staple behemoths.

For instance, the fund’s top three holdings—Procter & Gamble (NYSE: PG), Wal-Mart Stores (NYSE: WMT), and Philip Morris International (NYSE: PM)—soak up approximately 37% of assets, and its top ten holdings represent about 65% of total assets. Also worth noting is that about 75% of assets are allocated to consumer-goods firms, with the remaining 25% invested in nondiscretionary retailers.

Although the fund’s entire portfolio is domiciled in North America, the majority of these companies generate a significant portion of their sales and profits abroad. Therefore, a relatively weak US dollar over the past several years has provided a tail wind for these firms in the form of favorable foreign currency exchange rates. With the US dollar recently gaining strength against other major foreign currencies, however, those international tail winds could now turn into negative head winds.

The run up in commodities over the past several years has whacked the profits of some of these firms. However, with commodity prices paring back recently, many of these firms could see their input costs moderate, helping to offset potentially unfavorable currency translations.

The fund’s 0.23% expense ratio is low even by ETF standards. (It closed below $23 Friday—Editor.)

Investors seeking nondiscretionary exposure to the consumer have plenty of choices in the ETF world. For instance, Vanguard Consumer Staples (NYSEArca: VDC) (0.22% expense ratio) provides almost identical exposure as Select Sector SPDR.

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