The Industrial Select Sector SPDR (NYSEArca: XLI), the largest industrial exchange traded fund by assets, is higher by more than 20% year-to-date. Opportunity may remain in the cyclical sector, though some analysts believe the group’s valuations are fair at the moment.
XLI “seeks to provide precise exposure to companies in the following industries: aerospace and defense; industrial conglomerates; marine; transportation infrastructure; machinery; road and rail; air freight and logistics; commercial services and supplies; professional services; electrical equipment; construction and engineering; trading companies and distributors; airlines; and building products,” according to State Street.
When considering a sector pick, investors should still do their due diligence. For example, one should survey the macro economic environment and analyze business cycles, position according to changes in certain macroeconomic variables, identify secular industry trends, harness long-term growth trends within a particular segment, evaluate sector fundamentals, position towards areas that show attractive valuations and overweight or underweight sectors based on recent performance.
“Broadly speaking, demand remains healthy for most industrial companies. Despite a slight slowdown since the beginning of 2019, industrial production is up 2% year over year,” said Morningstar in a recent note. “Furthermore, tariffs appear to be a relatively minor threat for most large diversified industrials, as companies are countering the impact of tariffs by reining in costs, raising prices, and shifting production to where products are sold.”
Investigating the Business Cycle
As an overarching theme, investors should consider how to position in the slowdown or late stages of the normal business cycle. The slowdown period is characterized by capacity utilization peaks, positive output gaps, positive but decelerating growth and more restrictive monetary policy. In this type of environment, investors may find that consumer staples, healthcare, and industrials tend to outperform, whereas materials, consumer discretionary, and real estate segments tend to underperform.
“We see compelling opportunities among industrial distributors, as forward multiples remain below historical valuations,” said Morningstar. “Although it may be challenging for industrial distributors to match the impressive revenue growth they delivered in 2018, we still expect solid top-line growth in 2019.”
Robust cash flow is another favorable factor for the industrial sector.
“Furthermore, despite persistent gross margin pressure caused by the growing prominence of lower-margin national customer accounts, we expect distributors’ operating margins to improve as they realize strong operating leverage,” according to Morningstar. “An attractive aspect of the business is the countercyclical free cash flow due to reduced working capital requirements during downturns. This gives us confidence that industrial distributors will continue generating healthy cash flows even if economic activity slows down.”
For more information on the industrial sector, visit our industrial category.