Arthur: Buy XLI And PSCI

November 12, 2013



The way to play the above is through liquid, transparent and diversified exchange-traded funds. The Industrial Select Sector SPDR Fund (XLI | A-90) ETF gives you exposure to 65 names including General Electric, United Technologies, Boeing, Minnesota Mining and Union Pacific.

The embedded fees are 0.18 percent, and the median market capitalization, or large capitalization (I consider above $10 billion to be large), is $15 billion. XLI trades at 16.9 times trailing earnings and 3.3 times price-to-book. It yields just under 2 percent and generates almost 26 percent return on equity.

Based on 30 years of history, the current price-to-earnings is at the 50th percentile and the current price-to-book is at the 61st percentile. The third-quarter median expected growth rate is 8.6 percent, which is the second-best of the 10 industry sectors. For 2014, expected growth is 13 percent coupled with near-record profit margins.

Both of these factors should help drive the sector higher.


Source: Main Management

To complement the large-cap XLI, consider satelliting small-cap industrial exposure with the PowerShares S&P SmallCap Industrials fund (PSCI | B-49). PSCI has 84 holdings and an expense ratio of 0.29 percent.

Its median market capitalization is $1.8 billion, giving you unique exposure not expressed in XLI. It trades at twice price/book, a discount to the large-caps in part due to a lower ROE of 12 percent. The smaller companies are forecast to grow 18 percent for 2014, or almost 50 percent more than XLI. The trailing P/E is 21 times earnings.

In conclusion, the industrial sector has powerful secular drivers: manufacturing, automation and productivity. The group is not "undiscovered," but rather, trades at a fair valuation based on historical levels. Given the low-teen growth for the large-cap and high-teen growth for small-caps, the industrials should outperform the broader market in 2014.

Finally, if the current commodity cycle that started in 2002 is long in the tooth, it should benefit industrials. The last buying commodity cycle from 1982 to 2002 saw persistent outperformance from the industrials.

A pioneer in managing all-ETF portfolios, Main Management, LLC is committed to delivering transparent, cost-efficient, and customized investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, cost efficiency, tax awareness and transparency.


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