2023-08-30 01:10:45 ET
Summary
- Materials Select Sector SPDR Fund ETF is a passively managed fund that replicates S&P's Materials Select Sector Index.
- The fund is top-heavy, with the top 10 stocks accounting for 66% of its total weight, and Linde plc alone accounting for 20%.
- The materials sector is highly cyclical and dependent on global economic growth, with concerns about the Chinese economy potentially impacting the sector.
Materials Select Sector SPDR Fund ETF ( XLB ) is a passively managed sub-sector index fund that tries to replicate S&P's Materials Select Sector Index. The fund invests in roughly 32 companies that make up this index which also happens to be a sub-index within S&P 500 which means all this fund's holdings are also part of the larger index. The fund focuses on companies that produce, distribute and sell materials such as chemicals and minerals. The fund performs best when commodity and material prices are rising rapidly but its performance might be limited in the next couple years considering risks such as deflation risk in China and slowdown in the global economy which is why it is probably a "hold" right now.
The index is weighted by market cap and it's top heavy where the top 10 stocks account for 66% of its total weight not to mention Linde plc ( LIN ) alone accounts for 20% of the weight with its market cap of $194 billion which is almost as large as the next 3 companies combined. Headquartered in Ireland, Linde plc produces, distributes and sells industrial gases that are used by a variety of industries including but not limited to manufacturing and healthcare. The company also has an engineering business that offers highly specialized services such as gas processing, separation and liquefaction for its customers.
The fund also includes Air Products and Chemicals Inc ( APD ) which sells atmospheric gases such as oxygen, nitrogen, and argon, process gases like hydrogen, helium, carbon dioxide and carbon monoxide as well as specialty gases and related services, Sherwin-Williams ( SHW ) which distributes and sells paint and paint-related products and Freeport-McMoRan ( FCX ) which produces and sells a variety of minerals, copper, gold, silver, oil and gas.
Materials is a highly cyclical industry and depends on the growth of global economy for its growth. In the last few years there were concerns about availability of many materials first due to the effects of the COVID-19 pandemic and then due to the effects of the war in Ukraine. Both events disrupted production and supply chains for many material types which also contributed to the rise of the inflation we saw last year. This year many of these disruptions seem to be addressed and prices of many materials and commodities returned to more "normal" levels (or less elevated levels) but now the issue might be on the demand side moving forward.
China is one of the biggest drivers of global economic growth but lately there are signs of trouble in the country. After reopening from its latest cycle of COVID shutdowns, the country's economy didn't jumpstart as quickly as many people thought it would. This was most likely driven by a few factors such as high unemployment rates in youth, slowdown in real estate market driven by credit crunch and an overall caution of local population to spend money after living through multiple rounds of lockdowns. In most western countries COVID lockdowns lasted only a few months which had a booster effect driven by pent up demand in goods and services as soon as those lockdowns ended and people started to go out and spend money aggressively but China's lockdowns lasted much longer which also produced different results.
If China starts experiencing a deflation (i.e. the opposite of inflation where prices drop rapidly due to lack of sufficient demand), this could have serious negative impact on the materials sector. We don't know if this will happen for sure but there is a strong possibility at the moment. We've already seen the effects of slowdown in the Chinese economy but we haven't fully seen the response of the Chinese government and I feel like the government hasn't played all its cards yet in this matter.
On a positive side only about 16% of the fund is allocated towards Metal & Mining and another 6% on Construction Materials and these are the two sub-sectors that are most sensitive to what's going on in the Chinese economy. For the last 30 years China has been spending a lot of money and resources into building its infrastructure, supply chains and production capacity and this activity consumed a lot of metals, mined goods and construction materials, being a major driver of demand in these materials. We will have to see if this continues to be the case in the next year or so as China's economy continues to transform.
Apart from China's recent troubles, we haven't fully seen the effects of the Fed's tightening on the US economy, neither have we seen effects of what ECB is doing in Europe. Fiscal tightening tend to work with a lag and it can be many months before its full effects are observed in the economy. In the last year the US economy has proved to be exceptionally strong and resilient and this has surprised even the Fed members who were expecting unemployment rate to climb higher by now after many months of tightening. The Fed's current rate hike schedule has been one of the fastest in history, hiking from 0% to 5.5% in one short year, yet the unemployment rate has been largely unaffected to say the least, leaving many people puzzled but also hopeful about a soft landing. A soft landing scenario can definitely have positive effects on a fund like XLB considering how cyclical it is.
The fund trades at a trailing P/E of 21 and forward P/E of 19, neither of which seem particularly cheap but it doesn't look excessively expensive either. One metric where I find the fund expensive is price to cashflow which currently sits at 24.6 and this is significantly above what one would want to pay for an industry that is highly cyclical and might be in later stages of its cycle considering slowing down of the global economy even with the US economy showing a lot of resiliency.
The fund has a dividend history where it posts some dividend growth over time mostly driven by some of its largest holdings such as Linde. The fund's current dividend yield of 2% is not far from its decade-long average of 2.1% and happens to be in midpoint of its decade-long range of 1.6% to 2.4%. If this trend continues, investors can expect dividends to keep growing at an annual rate of 4-5% in most years unless we have global black swan event.
In the long run the fund tends to underperform the performance of the S&P 500 index ( SPY ) but this is mostly expected since most of SPY's outperformance came from mega cap tech stocks such as those stocks known as FAANG (plus Microsoft, Tesla and Nvidia). Moving forward I wouldn't be surprised if this underperformance continued for a while.
One of the major risks for my thesis is the possibility of inflation making a strong comeback. If inflation were to suddenly blow up again like it did in 1980s, commodities and materials would outperform while tech stocks that drive S&P 500's performance would most likely see a lot of volatility and ultimately suffer.
In conclusion XLB is a sector-focused passively-managed index fund that is top heavy where a few stocks at the top account for a great majority of its weight and 1 stock accounts for 20%. The fund represents a sector that is highly cyclical and would do well during booming times but likely underperform when things get rough. Given the slowdown of economies around the world (especially China) and possible lagging effects of the Fed's actions in the US, some caution in this fund might be warranted. Also, the fund isn't particularly cheap from a P/E standpoint and a bit pricey from a P/Cashflow metric one.
For further details see:
XLB Is A Hold Considering Risks Of Global Deflation Led By China