2023-11-14 05:24:13 ET
Summary
- Steel manufacturing industry is changing due to government policies and the shift towards recycling old steel.
- Pre-manufactured metal buildings are driving the growth of the steel industry.
- Increasing construction activity is driving up the demand for metallurgical and thermal coal.
Here's a quick trivia question: name a segment of the US stock market that for all of 2021, 2022 and much of 2023, consistently beat the performance of the S&P 500 Index? The answer, of course is the SPDR S&P Metals and Mining ETF ( XME ), the subject of this report. Amid an era of mega-cap outperformance and the fact that XME is a subset of the smallest of the 11 S&P 500 sectors (Basic Materials, accounting for only 2% of that index), there has been some outperformance here. See the graphic below.
Now, will it continue?
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My bottom-line answer is that XME doesn't look bad, but it also lacks the technical catalyst I look for to reward an ETF with a Buy rating. So it's a Hold, but one I follow to wait for the next time it produces the type of "blast off" move we've seen in the past. And, given the potential for investors to have a long-term guest in town (that being inflation), this is a market segment that would likely benefit from elevated prices of certain commodities. The expected boost in US infrastructure over the remainder of the decade is a potential fundamental catalyst as well.
Steel, coal and more
SSGA.com
Above we can see that XME is predominantly focused on steel, with coal and gold playing the main supporting roles. Given this, let's take a closer look at what is changing within those top 2 component industries.
Steel
As world government policies shift more towards de-carbonization and carbon off-setting, carbon-intensive hot metal or pig iron from blast furnaces is being substituted with recycling old steel, which is becoming more profitable than manufacturing new steel, given the mounting costs associated with carbon capture and offsets.
The growing popularity of Pre-manufactured Metal Buildings and their affordability, reduced construction costs, and higher quality welds, continues to be a driving factor in the growth of the steel industry, especially as costs continue to rise across supply chains for all building materials. As businesses and homeowners across the globe seek to improve construction to meet building and safety standards, as well as resist more extreme weather, high-quality steel is more in demand.
Coal
Coal mining, specifically metallurgic coal mining, is the other main holding within the top 10 holdings of XME . Metallurgical coal is used in smelting and manufacturing metals. Thermal coal is burned in plants for electricity. Increasing construction activity around the globe, due to rising populations, is driving up the demand for both metallurgical and thermal coal.
The adoption of innovative technologies for coal mining, including automated extraction equipment is reducing the need for manual labor and making coal mining more profitable. Innovation and technological advancements are also working towards mitigating environmental concerns and increasing efficiency.
XME: Structurally, just the way I like it
XME is large and liquid enough at $1.65 billion in assets and nearly $150 million in average daily trading volume. It has a total of 34 holdings, but the top 10 make up 45% of the fund. Those 10 are relatively balanced, with all 10 holdings making up between 4% and 5% of the fund each. This is one of the things I prefer in equity ETFs. I don't want to own hundreds of positions that don't "move the needle" when it comes to ETF performance. But I also don't want single-stock risk. The happy medium is a concentrated ETF, where about half of the performance is determined by 10-15 stocks, ideally. XME is an entirely US-focused stock ETF.
Of the top 10 holdings 4 are steel producers and 4 are coal mining companies. If you invest in XME, you know exactly what you're holding: US companies with steel and coal interests, and a sprinkling of precious metal mining and refining thrown in.
Taking a longer look than the chart shown earlier, we see this industry within the S&P 500 is more volatile than the S&P 500 ( SPY ) in general, and historically speaking, very cyclical. In the past decade XME has made 2 large peaks and troughs. In the best of times, it made 160% or more, twice. It also had drawdowns of about 40% and more than 60% at two different points in time. For all the talk about "long-term investing," this highly-cyclical part of the US equity market sends a clear message. Be prepared to rent it, not own it.
Quant Grade summary
The top 6 holdings of XME are concentrated towards steel and coal, as mentioned above, and all 6 are performing well, with Quant factor grades of A's and B's in value and profitability, as well as almost all A's in Momentum (except one C). This would make a case for XME retaining its value, and not dropping too low right now, with a strong foundation in good quality companies.
XME is essentially a subset of the Materials sector, so I wanted to see how it correlated to XLB, the ETF that tracks the capitalization-weighted version of that sector index. XME is naturally more volatile since it is less diversified, and the correlation, while positive, is not so high that I'd consider XME redundant with XLB. XLE can stand alone as a portfolio position.
Summary thoughts
My final decision mechanism is technical analysis, and XME doesn't show me enough right now to stand out. Rather, it is range-bound. But at some point, as in the past, market conditions should produce a breakout, and since it won't all happen in a day or a week, this is one to watch, not own for me right now. That's better than most of what I see in the market currently, where the choices are more like lose money slowly or lose money quickly! XME gets a Hold from me here.
For further details see:
XME: History Says It Will Likely See Strong Upside, Just Not Immediately