2023-06-15 17:35:17 ET
Summary
- For long-term investors, the Materials Select Sector SPDR Fund ETF presents a good buying opportunity.
- The materials sector trades at a discount, with a forward P/E of 16.7 versus the S&P 500's 18.5 times forward earnings, offering potential upside.
- The chemicals industry's earnings growth power is likely to support the share price and dividends.
- Risk factors include the possibility of a recession and volatility if the Fed resumes rate hikes in the second half of the year.
Better-than-expected economic data, slowing inflation, and a pause in rate hikes are all supporting the fundamentals of the Materials Select Sector SPDR® Fund ETF ( XLB ). Furthermore, XLB's greater emphasis on the chemical industry and lower concentration on the struggling metal & mining industry adds to the positive momentum. The earnings growth power of chemical companies would help their shares create a solid upside momentum and return significant cash returns to shareholders. Overall, XLB appears to be a solid investment for long-term investors, with attractive valuations, improving fundamentals, and solid earnings growth power of a large number of stock holdings.
Strengthening Fundamentals Supports XLB's Price Upside
Materials Sector Performance in Economic Cycles (ssga.com)
As the broader economy begins to recover from the severe stress seen in the previous two quarters, the materials sector is poised to outperform. This is because the materials sector, which primarily consists of companies engaged in chemical, mining, packaging, and construction products, outperforms during economic recovery and expansion but lags during contraction and recession. There are several reasons to believe that broader economic conditions will begin to improve in the second half of 2023. For example, the global economy is on the verge of recovering from the effects of both the pandemic and Russia's invasion of Ukraine. China, the second-largest economy in the world and a crucial market for mining and chemical companies reopened its economy and lowered interest rates to promote recovery.
Furthermore, with inflation returning to target, the Fed’s monetary tightening has almost reached its peak . The Fed appears to have met its goal of slowing inflation without sending the economy into a tailspin, which is ideal for the materials sector. During the press conference, Federal Reserve Chair Jerome Powell stated , "I continue to believe there is a path" to a soft landing. The robust job data and historically low unemployment rate continue to show signs of economic strength. Last month, the United States added 339,000 jobs, far exceeding forecasts of 190,000 jobs, and up from 253,000 jobs in April and 165,000 jobs in March. Overall, the US and global economies appear to be entering a recovery phase in the second half, which is good news for the cyclical materials sector.
Chemicals Industry Exposure Is a Plus
XLB Industry Exposure (ssga.com)
In contrast to the metals and mining sector, which has been struggling with lower commodity prices than the previous year, the chemicals industry has demonstrated resilience and continued to produce strong earnings growth. As of the end of the March quarter, the chemical industry accounted for 68% of XLB's portfolio, which I believe will be a key driver of share price and dividend growth in the coming quarters. For instance, with a weight of about 19%, the chemicals company Linde plc ( LIN ) is the largest stock holding in the XLB portfolio. Due to the company's strong revenue and earnings growth trends, its shares have increased by about 17% so far this year. The company's first-quarter earnings per share of $3.42 were up 17% year on year or 20% in constant currency terms. This is the tenth consecutive quarter of increasing EPS ex-FX by 20% or more. Furthermore, the company increased its adjusted EPS guidance for the full year to $13.45 to $13.85, representing a 9% to 13% increase over the previous year.
XLB Holding Breakdown (Seeking Alpha)
Air Products and Chemicals ( APD ), the second largest stock holding in XLB's portfolio, reported revenue growth of 8.5% year over year in the March quarter. Its adjusted EBITDA increased by 13% year over year. The company also raised its fiscal 2023 full-year adjusted EPS guidance to $11.30 to $11.50 per share, up 10 to 12 percent from the previous year. Sherwin-Williams ( SHW ), the third largest stock holding in XLB's portfolio, also belongs to the chemical industry. It reported 8% revenue growth in the March quarter and reaffirmed full-year 2023 adjusted diluted net income per share guidance in the range of $7.95 to $8.65 per share, up from $7.72 per share in the previous year. There is a good chance that their financial growth will continue in the second half and coming year, as economic trends have begun to improve, inflation has slowed, and interest rates have reached their peak.
Metals and mining companies, on the other hand, are also likely to benefit from slowing inflation and a better overall economic outlook. China's policy of lowering interest rates and implementing economic stimulus is also expected to boost demand for metal and mining companies such as Freeport-McMoRan ( FCX ) and Newmont Corporation ( NEM ). Meanwhile, the container and packaging industries are also expected to benefit from low inflation and improved supply-chain dynamics. Packaging companies typically have stable business models with strong cash generation potential due to their exposure to a large number of end markets.
Valuations and Quant Ratings
Materials Sector Forward PE (yardeni.com)
The materials sector trades at a discount, with a forward PE of 16.7 versus the S&P 500's 18.5 times forward earnings. With the exception of industrial gases, the rest of the industries in the materials sector, including diversified chemicals and specialty chemicals, trade at a discount to the broader market index. Furthermore, with the economic recovery and potential earnings growth, the sector has more upside without significantly changing forward PE.
XLB's Quant Ratings (Seeking Alpha)
XLB currently has hold ratings with a quant score of 2.98, but I anticipate an increase in its quant rating in the coming months. This is due to a possible increase in its share price, which could raise the momentum score and lower the risk factor. A plus grade on the liquidity factor indicates that trading volume is increasing rapidly. This means that investors remain optimistic about future fundamentals. XLB has raised dividends for the past two years in a row, and the earnings growth trends of its portfolio holdings suggest that its dividend yield of more than 2% is safe.
Risk Factors to Consider
XLB's Performance in Recession (ssga.com)
Although I believe the economy will recover in the second half, there is still the possibility of a recession because the Fed has only paused rates rather than pivoting. If the Fed resumes rate hikes in the second half, XLB's stock price may experience volatility. Historical data also shows that the cyclical materials sector suffers during recessions. The chemical industry appears to be resilient in the event of a recession in the second half, but XLB's exposure to the mining & materials industry may have a negative impact on its share price and dividend performance.
In Conclusion
The underperformance of the Materials Select Sector SPDR® Fund ETF so far in 2023 in comparison to the broader market index appears to be a good buying opportunity for long-term investors who can tolerate short-term volatility. Furthermore, the earnings growth power of the chemical industry is likely to support XLB's share price and dividends. Overall, with a low expense ratio, high liquidity, and solid dividend yield, XLB could be the right option for investors with long-term investment horizons.
For further details see:
XLB: A Right Time To Buy With Long-Term Investment Horizon