XLI: A solid industrial ETF for healthy risk-adjusted returns

As stock market volatility has increased, it may be the right time to move away from risky stocks to low-volatility sectors such as industrials. The sector is comprised of a large number of industries and top dividend paying stocks. In addition, the industrials sector looks fundamentally sound, with growing prospects for a soft landing, steady economic expansion, and double-digit earnings growth power through 2025. In my recent articles, I’ve highlighted two solid industrials ETFs: Vanguard Industrials ETFs (DREAM) and the iShares US Industrials ETF (IYJ). Both ETFs generated double-digit total returns last year. VIS has product 12% in total return, while IYJ shareholders ACCOMPLISHED 11% of the total yield. In this article, I look at The Industrial Select Sector SPDR® Fund ETF (NYSEARCA: XLI), an industrialist ETF with targeted exposure to the best performing stocks in the sector. I initiate coverage of XLI with a Buy rating.

Fear drives the market

After swinging mostly between greed and extreme greed last year and into the first quarter of 2024, CNN’s Fear and Greed Index, which is composed of seven technical factors, has been in a state of fear. Fear is currently driving the market, despite a recent rally in share prices.

In addition to technical indicators, it appears that investor fear is largely due to the high valuation of technology stocks. Given the tech sector and Mega-8’s biggest contributor to the bull run over the past eighteen months, their future performance can also swing the markets either way. The Mega-8 group currently trades at over 27 times forward earnings, up from the group’s 5-year and 10-year average. NVIDIA ( NVDA ), the star performer over the past eighteen months, currently trades at about 48 times forward earnings, compared to the sector median of 28 times. Similarly, Microsoft ( MSFT ), Tesla ( TSLA ), Amazon ( AMZN ), Alphabet ( GOOG ) ( GOOGL ), Meta ( META ), and Apple ( AAPL ) received weak grades on their valuation factor based on Seeking’s quantitative analysis Alpha. Historically, whenever the valuation increases at a high rate, the price correction occurs to fix the valuation with the long-term average. The risk of a correction is high in the coming months for the tech sector and the Mega-8 given their expensive valuations.

The S&P 500 also looks overvalued, with a forward PE of 21x, compared to a 5-year average of 19.4x and a 10-year average of 17.9x. Room for more upside is limited, as a small percentage increase in price can send forward PE to around 23x, a level last seen in mid-2021. The index collapsed in late 2021 and remained in a bear market on throughout 2022. Moreover, expectations for third-quarter and full-year earnings growth fell to 5% and 10%, respectively. At the end of the second quarter, Wall Street was expecting third-quarter and full-year earnings of around 7% and 11%, respectively.

The industrial sector is fundamentally sound

It is generally believed that the industrial sector will perform well in expansionary phases, while remaining under pressure in contractions. Economic growth currently appears to be moderate, with US GDP growing 2.8% in the June quarter, compared to expectations for a 2% increase. Economists at Goldman Sachs cut their probability of a recession to 20% from 25% in the next year. Moreover, they anticipate reducing the probability of a recession back to 15% in the event of another strong employment report. Goldman economists also expect a 25 basis point rate cut at the Fed’s September policy meeting.

From an earnings perspective, the industrials sector looks strong due to expectations of mid-single-digit revenue growth in 2024 and high double-digit growth the following year. In the June quarter, 82% of companies in the sector reported better-than-expected earnings. Growth was strong across the sector, with aerospace and defense leading the momentum for earnings growth. The machinery, construction, electrical equipment and ground transportation industries also beat expectations. In addition, most companies in the sector provide shareholders with solid cash returns in the form of increased dividends and share buybacks.

XLI could be a better investment option than VIS and IYJ

The Industrial Select Sector SPDR® Fund ETF appears to be a better investment vehicle than its peers due to several factors, including portfolio structure, high liquidity, solid dividend growth and low expense ratio. The ETF provides targeted exposure to the best performing companies in the industrial sector. Its portfolio consists of 78 companies across a dozen industries, with aerospace and defense accounting for 23% and machinery accounting for 19% of the entire portfolio.

His top 10 holdings include well-established companies with solid fundamentals. For example, GE Aerospace (GE), Caterpillar (CAT), RTX (RTX), Uber Technologies (UBER), Lockheed Martin (LMT), Union Pacific (UNP) are among the companies with long histories and strong fundamentals. Besides Boeing ( BA ), the rest of its top 10 stocks have delivered healthy price and dividend gains over the past twelve months. In fact, a few companies performed exceptionally well due to their strong financial performance. For example, shares of GE Aerospace are up nearly 90% over the past twelve months, while Uber Technologies has produced a 66% price gain. RTX and Eaton Corporation’s stock price has risen nearly 35% over the past twelve months.

In the second quarter, GE Aerospace reported double-digit profit growth and raised its full-year earnings outlook. Aerospace and defense companies such as RTX and Lockheed Martin also beat second-quarter expectations and raised their full-year guidance. Caterpillar, Honeywell International ( HON ), Uber Technologies, Eaton Corporation ( ETN ), and Automatic Data Processing ( ADP ) also beat second-quarter revenue and earnings estimates, with most of them raising their top and bottom line expectations. down.

On the other hand, Vanguard Industrials Index Fund ETF Shares and iShares US Industrials ETF provide broader exposure to the industrials sector. VIS tracks the performance of the MSCI US Investable Market (IMI)/Industrials 25/50 Index, while IYJ tracks the performance of the Russell 1000 Industrials 40 Act 15/22.5 Daily Capped Index. The stock portfolios of VIS and IYJ are composed of 388 and 190 stocks. It is true that diversification helps lower volatility, but sometimes significant diversification lowers the potential for profit and increases volatility. Given XLI’s beta below 1 over the past 36 months, it appears that a concentrated portfolio of top-performing stocks may offer lower volatility. Meanwhile, the average beta of VIS and IYJ has been around 1.05 over the past 36 months.

XLI’s expense ratio of 0.09% is also lower than its peers. The expense ratio of VIS and IYJ is 0.10% and 0.40% respectively. The expense ratio plays an important role when it comes to long-term total return. The ETF also looks better based on dividend growth and yield. XLI offers a dividend yield of 1.45% and a three-year dividend growth rate of nearly 13%. The dividend yield of VIS and IYJ is lower than XLI, with a 3-year dividend growth rate of 12% and 9.28%, respectively. A liquidity factor is also important as it facilitates the trading process and helps reduce bid-ask spreads. XLI has $19.15 billion in assets under management, compared to VIS and IYJ’s $5.79 billion and $1.24 billion. Its trading volume of USD 1.2 billion significantly exceeds VIS and IYJ’s trading volume of USD 18 million and USD 7.6 million.

Looking up Alpha’s quant rating also confirms my position. XLI earned a buy rating with a quant score of 3.86. VIS received a buy rating, but its quant score of 3.60 is lower than XLI. Meanwhile, IYJ earned a hold rating based on a quant score of 3.25. In addition to the risk factor, XLI outperformed or scored similarly on the remaining four factors compared to its two peers. XLI’s D-plus grade on one risk factor is mainly due to its low diversification compared to peers. However, I believe that targeted exposure to the industrial sector by holding a stake in the best performing companies may be a better strategy given the uncertain market conditions.

In conclusion

Industrials appear to be one of the best sectors for investors seeking healthy risk-adjusted returns over the long term. The sector is currently in a solid fundamental position thanks to the outlook for stronger-than-expected economic growth and solid earnings performance from corporates. There are numerous investment tools that investors can use to benefit from the strong outlook of the industrial sector. One of the best ways is to invest through exchange-traded funds such as The Industrial Select Sector SPDR® Fund ETF, Vanguard Industrials Index Fund ETF Shares and iShares US Industrials ETF. However, in my view, The Industrial Select Sector SPDR® Fund ETF is the best ETF among its peers given its targeted exposure to the industrial sector, low expense ratio, healthy liquidity and high dividend yield.