Arthur: Buy XLI And PSCI

November 12, 2013

ETFs to play America's industrial comeback, from Main Management's Kim Arthur.

This is the first of a regular series of thought-leadership pieces from some of the more-influential ETF strategists in the money management industry. Today's article features Kim Arthur, chief executive officer and founding partner of San Francisco-based Main Management.

Industrials right now are a play on the revival of manufacturing, automation and productivity gains in the United States and globally.

Two ETFs come to mind as appropriate tools for investors to use here: XLI from State Street Global Advisors, and the small-cap-focused PSCI from PowerShares. But first, a bit of background.

For the past 60 years, ending in 2009, the U.S. was in a secular manufacturing decline. Driven by lower labor costs offshore and foreign-mandated industrial manufacturing initiatives, U.S. manufacturing shrunk from 28 percent of gross domestic product in 1953 to a low of 11 percent of GDP in 2009.

Today this figure stands at 12 percent, and is being driven higher by vehicle sales, a rebound in housing and continued energy exploration.

Vehicle output is currently 2.8 percent of GDP, still below its 50-year mean of 3.5 percent. That said, the current stock of vehicles is more than 11 years old, and the aging fleet of vehicles is helping to drive a replacement cycle that is likely to emphasize new technologies like electric and natural gas.

At the same time, housing has snapped its six-year bear market and now represents 3 percent of GDP, down from its 50-year mean of 4.5 percent. However, new-family formations have been below trend for multiple years, and are now reverting to their mean and helping to drive this space.

Finally, the U.S. has achieved energy independence with coal and natural gas. Oil still has an import gap driven by passenger vehicles that predominantly use oil. With miles per gallon equivalent (MPGE) of 89 for electric cars and 31 for natural gas, compared with 28 for traditional cars, the goal of oil independence is moving in the right direction.

On the productivity front, U.S. manufacturers are more productive than their British, Japanese and German counterparts. Additionally, the rate of change of U.S. unit labor costs has been flat, helping to drive a growing dominance in this space. As global purchasing managers indexes continue to look up, this rise will drive demand for the industrial sector.

Manufacturing PMIs And XLI Price

1_PMIs vs XLI Price

Sources: Markit, Main Management

Also, as chief executive officer confidence levels rise, driven by increased visibility of demand, CEOs will begin to increase corporate capital expenditures. Those increases are in turn highly correlated to upward revisions to earnings per share.

As you can see from the chart below, confidence is ahead of an EPS uptrend that should follow.



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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