An ETF for a Stronger Manufacturing Sector

Morningstar's Take
The United States industrials sector continues to benefit from a slow and steady expansion. In November 2013, the manufacturing ISM report showed growing economic activity in the manufacturing sector for the sixth consecutive month, with across-the-board strength. The headline number is the manufacturing Purchasing Managers' Index number, which hit 57.3 in November, a gain from October's reading of 56.4 and its highest level in the past year. (Any reading above 50 indicates that the manufacturing economy is generally expanding.) And over the past 12 months, the PMI figure has been above 50 for all but one month.

We would caution investors from taking too much away from any one-month (or even two-month) reading. The reason is that if the 57.3 PMI for November is annualized, it would correspond to a 4.7% increase in real GDP. That's a level at which few believe the U.S. economy is capable of growing anytime soon. However, even averaging monthly PMI figures across the past 12 months results in a robust reading of 53.4.

For investors interested in a diversified basket of U.S. industrials-sector companies, we recommend the exchange-traded fund Vanguard Industrials ETF (VIS). The main subsectors covered in this fund are aerospace and defense firms, industrial conglomerates, industrial machinery companies, and manufacturers of construction and farming machinery and heavy trucks.

Many of VIS' holdings have significant sales outside of the U.S., giving this fund some exposure to global growth trends. At the same time, the U.S. industrials sector is exposed to a meaningful amount of cyclicality. That cyclicality, coupled with a narrow sector focus, make this fund more volatile than other, broader ETFs. Over the past five years, this fund's volatility of return has been 22.0% compared with 15.8% for the S&P 500. This above-average volatility is partly attributable to the industrial sector's cyclicality.

The ETF also has the lowest expense ratio of any large and liquid U.S. industrials ETF. It's suitable as a tactical investment, only for the satellite portion of a diversified portfolio.

Fundamental View
As indicated above, sentiment indicators remain high across the board in the industrials sector. Morningstar's equity analysts have noted that companies have adjusted nicely to the current growth environment and largely have been delivering healthy profitability. Despite the U.S. government shutdown, industrial demand--in the form of PMI numbers--has remained strong in the U.S. and, surprisingly, in Europe. In fact, Europe's PMI reading recently pushed over 50 for a sustained period, led by the British service sector. The recovery in Europe and the strength in the U.S. have been offset a bit by the impact of moderating Chinese growth on industrial companies.

Given their impact on the U.S. housing market, the specter of rising interest rates is a concern and is something that investors in industrials companies should watch closely. Housing demand remains generally strong, but rising interest rates tempered demand in the summer of 2013, and a labor shortage further exacerbated matters, lengthening build times. That said, in late 2013, the housing sector has rebounded nicely, with strong growth in homebuilding permits (fueled in part by multiunit residential projects in the Sunbelt) and a battery of other rosy housing reports. Despite these strong results, it's worth noting that the homebuilding sector actually has meaningfully underperformed both the S&P 500 Index and this ETF in 2013, likely because investors are looking ahead and anticipating further rate increases. As a result, while interest rates may rise in 2014 as many are predicting, it's not certain that such increases would meaningfully hurt the housing industry. Depending upon the magnitude of interest-rate hikes, it's possible that those increases already have been priced in to companies' share prices.

Overall, Morningstar's equity analysts expect industrial production to continue to grow at a steady pace--likely in the low single digits--driven by conglomerates, housing, and auto production. Our analysts remain concerned about durable-goods orders and emerging markets. If nonresidential (commercial) construction finally turns a corner, we would expect later-cycle capital goods manufacturers held in this ETF such as Emerson Electric (EMR), Caterpillar (CAT), and Parker Hannifin (PH) to benefit. If the international picture strengthens, we would expect transport and logistics firms such as Expeditors (EXPD), C.H. Robinson (CHRW), United Parcel Service (UPS), and FedEx (FDX) to benefit.

General Electric (GE) is VIS' largest holding at more than 12% of assets and merits a closer look. Continually aiming to be a leader in every one of the markets in which it competes, GE has done a solid job pruning its lines of business with limited economic moats and investing in its remaining wide-moat businesses. The result is a mostly late-cycle conglomerate that excels at generating service revenue and has very strong economies of scale, particularly when it comes to research and development.

Recently, GE announced its intention to exit the North American retail finance business over the next two years. Morningstar's equity analysts like this move, as it will strengthen GE's already-wide moat by shifting its earnings mix toward its more-competitively advantaged industrial arm. Over the longer term, GE should remain a leader in energy equipment (with a heavy focus on clean-energy products, regardless of the fuel source), health-care equipment, and aviation, although with the divestiture of NBC Universal and the declining weight of lighting and appliances, the company may become somewhat more cyclical.

While VIS' historical performance suggests that it should function well as a cyclical play, some factors may make VIS' future performance relative to the broader market less predictable. VIS invests 22% of its assets in aerospace and defense companies. Defense contractors in particular are more sensitive to government spending than the overall business cycle, and given ongoing sequestration, we expect defense spending to slow in coming years.

One concern about this ETF is its valuation. Like much of the U.S. equity market, VIS has a fairly rich valuation. According to Morningstar's equity analysts, VIS currently is trading at 105% of its fair value, while the S&P 500 Index trades at 102% of its fair value. So investors should become comfortable with the valuation before investing.

Portfolio Construction
VIS tracks the MSCI U.S. Investable Market Industrials 25/50 Index, which measures the return of stocks in the industrials sector, and holds 357 companies. The index contains the industrial companies found in the MSCI U.S. Investable Market Index, which is a broad, cap-weighted index representing approximately 98% of the U.S. market capitalization. Note that VIS does not hold any steel or materials companies. Investors looking for exposure to that sector can consider the Materials Select Sector SPDR (XLB) or Vanguard Materials (VAW).

Fees
VIS' annual expense ratio is 0.14%, which is the lowest of any large and liquid industrials-sector ETF. Its estimated holding cost is even lower at 0.13%. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share-lending revenue.

Alternatives
For industrials-sector exposure, we also like Industrial Select Sector SPDR (XLI), which holds 64 companies, is very liquid (and in fact is many times more liquid than VIS), and has a very attractive expense ratio of just 0.18%.

The performance and returns of VIS and XLI are highly correlated. The two funds do have small portfolio differences. VIS holds airline companies, while XLI does not. Also, XLI has slightly higher exposure to aerospace and defense companies (26% of assets) than does VIS (22%).

A recently launched and very inexpensive option is Fidelity MSCI Industrials Index ETF (FIDU), which charges 0.12%. However, FIDU has minimal assets and is thinly traded. FIDU tracks a slightly different index from Vanguard Industrials ETF; FIDU tracks the MSCI USA IMI Industrials Index, while VIS tracks the MSCI US Investable Market Industrials 25/50 Index. Fidelity customers with a minimum balance of $2,500 can buy FIDU commission-free, although beginning Feb. 1, 2014, they are subject to a short-term trading fee by Fidelity.

Investors seeking more global industrials exposure in the form of firms like Siemens AG (SI), ABB Ltd. (ABB), Mitsubishi Corp., Schneider Electric, and Vinci SA should consider iShares Global Industrials (EXI), which holds U.S. industrial names (which account for 51.5% of the portfolio) and international industrial companies; it charges a fee of 0.48%. EXI has meaningfully underperformed VIS over the past one-, three-, and five-year periods, likely because of EXI's 15% weighting to Japanese stocks and its meaningful exposure (almost 30%) to European companies.

Robert Goldsborough does not own shares in any of the securities mentioned above.

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