Returning To Industrial ETFs

Industrial stocks and corresponding exchange-traded funds have been laggards this year. The Industrial Select Sector SPDR (Sector Spdr Trust Sbi XLI), the largest industrial ETF, is locked in a battled with the Select Sector Financial Slct Str SPDR Fd XLF for the dubious honor of the third-worst sector SPDR on a year-to-date basis.

And to this point in the year, three of XLI's marquee holdings also happen to be three of the 16 members of the Dow Jones Industrial Average that are in the red. Other data points confirm investors' reluctance to embrace cyclical industrial stocks. For example, short interest in XLI was recently as high as 59 percent of shares outstanding, according to AltaVista data. That's well ahead of the sector SPDR with the second-highest short interest – the Materials Select Sector SPDR – at 44 percent.

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Investor Interest In XLI

On the other hand, some data points suggest investors are nibbling at XLI. Month-to-date, more than $829 million in new assets have been added to XLI. For the week ended October 13, XLI took in $761.6 million in new money, a total exceeded by just four other ETFs.

AltaVista's Take

For its part, AltaVista Research has a neutral rating on XLI.

“A rating of Neutral (emphasis deleted) is assigned to funds with ALTAR Scores between 6.0 percent and 8.0 percent. This indicates that valuations adequately reflect the fundamentals of stocks in these funds. The majority of funds we cover fall into this category,” said the research firm in a recent note.

Enthusiasm To Be Tested Later This Week

Any recently built enthusiasm for XLI and rival industrial ETFs will be tested later this week when Dow component General Electric Company GE reports third-quarter earnings. General Electric is XLI's largest holding at a weight of 11.1 percent. That is nearly double the weight the ETF assigns to its second-largest holding, 3M Co MMM, which also happens to be one of the three industrial stocks weighing on the Dow this year.

Why XLI?

For investors looking for what appears to be a solid sector idea based on valuation, it is hard to beat XLI. AltaVista estimates XLI's 2015 price-to-earnings ratio at 14.8 compared to 16.3 for the S&P 500. Only the Financial Select Sector SPDR is less expensive in P/E terms.

Still, XLI will need some help in the form of rebounding oil prices and/or improved rail traffic to mount a legitimate rally. Road and rail stocks are 9.3 percent of the ETF's weight, the fund's fourth-largest industry allocation.

“The shale oil & gas revolution is contributing to a manufacturing renaissance that has resulted in rising margins and faster long-term EPS growth. However revenues could be down this year due to the strong USD and the soft economy, evident in the negative estimate revisions.

“However, the sector's P/E multiple has held fairly steady even as the market's P/E has risen, boosting Industrials' attractiveness to slightly above that of the S&P 500,” said AltaVista.