Materials stocks and related exchange traded funds have fallen behind the broader market but the sector can turn around on improving economic growth.
Investors interested in the materials space can consider the Vanguard Materials ETF (NYSEArca: VAW), a cheap and comprehensive U.S. materials-sector fund that offers exposure to most publicly traded U.S. materials companies, writes Morningstar analyst Alex Bryan.
Specifically, VAW tracks the MSCI US Investable Market Index(IMI)/Materials 24/50 Index. The ETF includes materials sector stocks taken from the parent MSCI USA Investable Market Index, which makes up about 99% of the U.S. stock market, including companies engaged in chemicals, metals and mining, paper and forest products, containers and packaging, and construction materials industries.
However, materials sector stocks are exposed to greater risks, especially its cyclical nature, but the space may also prove profitable during periods of economic growth.
“Most of these companies sell into cyclical commodity markets,” Bryan said. “They also have to contend with volatile raw-material and energy prices and high fixed costs. The fund’s broad reach into small- and mid-cap territory makes it more susceptible to these operational risks. During the past five years, this fund was about 50% more volatile than the S&P 500.” [Sector ETFs for Rising Rates]
While some larger companies like Monsanto (NYSE: MON), DuPont (NYSE: DD) and PPG Industries (NYSE: PPG), have created competitive advantages, many of the smaller and mid-sized firms lack the economic moats, which make them more susceptible to cyclical demand.
VAW includes a 57.5% position toward large-cap stocks, along with 30.4% in mid-caps, 9.2% in small-caps and 2.9% in micro-caps.
In the chemicals space, Bryan argues that margins could contract as chemical products add new capacity. However, chemical producers are shifting into less-cyclical, high-margin specialty products, but most are still dependent on cyclical basic chemicals.
The fertilizer and agriculture chemical makers also have significant exposure to crop prices as farmers’ incomes are tied to demand. Nevertheless, Bryan believes the long-term outlook remains in place as growing demand for food will support the space, notably from a rising middle class in the emerging markets. [A DuPont Breakup?]
Industrial metals are also tied to growth in the emerging markets as well, specifically China and its infrastructure projects. This space could face headwinds as China shifts from its investment-driven growth model.
Furthermore, miners, particularly gold miners, will have to adapt to falling gold prices while costs remain elevated. Still, the area is trading near record lows and some market observers are waiting for a rebound. [Reason for Optimism With Miners ETFs]
VAW’s sub-sector allocations include commodity chemicals 7.8%, construction materials, 2.5%, diversified chemicals 18.1%, diversified metals & mining 5.7%, fertilizers & argicultural chemicals 11.0%, gold 2.3%, industrial gasses 8.7%, metal & glass containers 3.7%, paper packaging 5.7%, paper products 3.7%, specialty chemicals 21.4% and steel 6.3%. [Bumps in the Road for the Steel ETF]
For more information on the materials sector, visit our materials category.
Max Chen contributed to this article.