Looking At Drivers For Industrial ETFs

The Industrial Select Sector SPDR XLI, the largest exchange traded fund dedicated to industrial stocks, is up 7.4 percent year-to-date, which slightly trails the S&P 500. That's still a steady performance considering weakness displayed some diversified industrial conglomerates this year, a group that's a pivotal part of XLI and other industrial ETFs.

For example, shares of Dow component General Electric Company GE are down nearly 10.6 percent year-to-date. General Electric, XLI's largest holding at 8.4 percent of the ETF's weight, is one of just two Dow stocks down at least 10 percent this year. Behind aerospace and defense stocks, industrial conglomerates are XLI's second-largest industry weight at 19.8 percent.

Good News?

There could be good news for some diversified industrial names, including some XLI components.

“Sales at diversified industrial companies are expected to grow slightly in 2017 following sales declines in 2015-2016,” said Fitch Ratings in a recent note. “Signs of a recovery were evident in the first quarter of 2017 when most diversified industrials reported improving sales trends, although conditions remain mixed across sectors and geographies. Prospects for capital goods companies that produce machinery and engines are also improving, but at a slower pace. The sustainability of early improvements in orders and sales will be in focus through at least mid-2017.”

Although shares of GE are sliding, some rivals are performing well this year. For example, 3M Co. MMM and United Technologies Corp. UTX, two of XLI's top 10 holdings, are two of the 12 Dow stocks up at least 10 percent this year. Boeing Co. BA and Caterpillar Inc. CAT, two more XLI top 10 holdings, are two of the other Dow stocks up at least 10 percent this year.

Penchant For Buybacks

A theme long-term investors should monitor is the industrial sector's buyback penchant, which is largely funded with corporate debt. Industrial companies have been buying back their own shares amid pressure to juice returns.

“A slow-growth environment and shareholder pressure to boost returns are contributing to aggressive cash deployment by diversified industrial companies and a willingness to fund share repurchases with debt,” said Fitch. “Most stock buybacks are expected to be done in a credit-neutral manner, although they will continue to be a constraining factor on credit quality. Slow growth and pressure from activists are also driving acquisitions, divestitures and realignments, cost reductions and other restructuring efforts. Investor activism is affecting both highly rated and low-rated issuers including General Electric, Honeywell, Navistar and others.”