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We rec­om­mend investors avoid all mate­ri­als sec­tor ETFs. We found no ETFs in the mate­ri­als sec­tor that offer investors attrac­tive invest­ment merit and accept­able struc­tural integrity. We rate the invest­ment merit of the top six mate­ri­als sec­tor ETFs.

Per our first-quarter-2011 review of U.S. Equity Sec­tor ETFs, the mate­ri­als sec­tor is one of five sec­tors that gets our “neu­tral” rat­ing. Fig­ure 2 shows how the mate­ri­als sector’s stocks and the mar­ket value attrib­uted to them stack up under the micro­scope of our stock rat­ing sys­tem. Unlike other neutral-rated sec­tors, like the util­i­ties sec­tor, the mate­ri­als sec­tor has quite a few, 25 to be exact, stocks that we rate attractive-or-better. And the sec­tor only has six stocks that are ranked “very dangerous."

[Click all to enlarge]

Fig­ure 1: Mate­ri­als Sec­tor – Cap­i­tal Allo­ca­tion & Hold­ings by Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

The mate­ri­als sec­tor has 46% of its value in dangerous-or-worse-rated stocks com­pared to only 35% of its value in attractive-or-better-rated stocks. Rel­a­tively high allo­ca­tion to dangerous-or-worse-rated stocks causes the mate­ri­als sec­tor to earn our neu­tral over­all risk/reward rating.

The key take­away here is that the mate­ri­als sec­tor offers both good and poor invest­ment oppor­tu­ni­ties. The invest­ment value of each ETF is derived from its con­stituents, so ETFs that over­weight attractive-or-better-rated stocks are great invest­ment oppor­tu­ni­ties while ETFs that over­weight neutral-or-worse-rated stocks should be avoided.

When ana­lyz­ing the mate­ri­als sec­tor ETFs, we started by iden­ti­fy­ing those ETFs with accept­able struc­tural integrity as mea­sured by XTF, an ETF research firm. We chose the six ETFs whose XTF rat­ing was above the sec­tor aver­age XTF rating.

Fig­ure 2: Mate­ri­als ETFs With Accept­able Struc­tural Integrity

Sources: New Con­structs, LLC; XTF and com­pany filings

Fig­ure 2 shows clearly that not all mate­ri­als ETFs are made the same. Dif­fer­ent ETFs have mean­ing­fully dif­fer­ent num­bers of hold­ings and, there­fore, dif­fer­ent allo­ca­tions to hold­ings. Given the dif­fer­ences in hold­ings and allo­ca­tions, these ETFs will likely per­form quite differently.

After deter­min­ing the struc­tural integrity, we ana­lyzed the invest­ment merit of each ETF based on how it allo­cated value to each stock it held. Fig­ure 3 shows how the six mate­ri­als sec­tor ETFs stack up ver­sus each other and the over­all sec­tor based on their over­all risk/reward rat­ings and the allo­ca­tion of their hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allocations

Sources: New Con­structs, LLC; XTF and com­pany filings

Attrac­tive ETFs:

We find no attractive-or-better-rated ETFs.

Neu­tral ETFs:

PYZ, XLB, VAW, FXZ, and IYM allo­cate their value in a way that earns a Neu­tral Over­all Risk/Reward rat­ing. Of the six ETFs cov­ered in this report, First Trust Mate­ri­als AlphaDEX Fund (FXZ) is the only ETF whose com­po­si­tion is deter­mined using “Var­i­ous Fun­da­men­tals.” One has to won­der what fun­da­men­tals First Trust is using to cre­ate an ETF where over 70% of its value is allo­cated to Neutral-or-worse-rated stocks. We rec­om­mend investors buy the Very Attrac­tive and Attrac­tive stocks in this sec­tor before buy­ing any of the Mate­ri­als ETFs we cover in this report.

Dan­ger­ous ETFs:

We rec­om­mend investors avoid or short RTM because of its Dan­ger­ous Over­all Risk/Reward rat­ing. Fig­ure 3 con­trasts the dif­fer­ence in invest­ment merit between PYZ, RTM and the over­all sector.

Bench­mark Comparisons Sec­tor Benchmark

PYZ and the over­all sec­tor have com­pa­ra­ble quality-of-earnings rat­ings. IYE and the sec­tor earn Very Attrac­tive Eco­nomic vs. Reported Earn­ings rat­ings because their Eco­nomic Earn­ings are pos­i­tive and ris­ing while Reported Earn­ings are decreas­ing. Also, IYE and the sec­tor have iden­ti­cal ROIC’s of 9.6%

PYZ man­ages to out­per­form the sec­tor in val­u­a­tion rat­ings. PYZ has a Price-to-EBV of 1.3, earn­ing it an Attrac­tive rat­ing, and a GAP of 32 years com­pared to the over­all sector’s Price-to-EBV of 1.7 and GAP of 43 years.

Fig­ure 4: PYZ – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 5: Mate­ri­als Sec­tor – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

PYZ more effec­tively allo­cates cap­i­tal than the over­all Mate­ri­als sec­tor. Per Fig­ure 3 above, PYZ allo­cates 28.7% of its value to Attractive-or-better-rated stocks while the sec­tor only allo­cates 25.7%. PYZ also allo­cates 20.6% of its value toward Dangerous-or-worse-rated stocks com­pared to the sector’s Dangerous-or-worse weight­ings of 45.5%.

Mar­ket Benchmark

The S&P 500 out­per­forms PYZ in qual­ity of earn­ings rat­ings. The S&P 500 and PYZ have the same Eco­nomic vs. Reported Earn­ings rat­ings but the S&P 500 has an ROIC of 18.3%, earn­ing it a Very Attrac­tive rat­ing, which nearly dou­bles PYZ’s ROIC of 9.6%.

The S&P 500 and PYZ have com­pa­ra­ble val­u­a­tion rations. Although they have the equal rat­ings, the S&P 500’s FCF Yield of 2.4% is mar­gin­ally bet­ter than PYZ’s FCF Yield of 2.0%.

Fig­ure 6: PYZ – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 7: S&P 500 – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

The S&P 500 more effec­tively allo­cates cap­i­tal than PYZ. Per Fig­ure 3 above, PYZ allo­cates 28.7% of its value to Attractive-or-better-rated stocks while the S&P 500 allo­cates 42.3%. PYZ also allo­cates 20.6% of its value toward Dangerous-or-worse-rated stocks com­pared to the S&P 500’s Dangerous-or-worse weight­ings of 23.7%.

Method­ol­ogy

This report offers rec­om­men­da­tions on Mate­ri­als sec­tor ETFs and bench­marks for (1) investors con­sid­er­ing buy­ing mate­ri­als sec­tor ETFs and for (2) com­par­ing indi­vid­ual ETFs to the mate­ri­als sec­tor and the S&P 500. Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (148 com­pa­nies) based on data as of April 19. We aggre­gate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to ana­lyze ETFs in the same way they ana­lyze indi­vid­ual stocks.

To make an informed ETF invest­ment, investors must consider:

1) The struc­tural integrity of the ETF and its abil­ity to ful­fill its stated objec­tive. We use XTF to find the top six ETFs with the best struc­tural integrity rating.

2) The qual­ity of the ETF’s hold­ings. We deter­mine and ETF’s qual­ity using our over­all risk/reward rat­ing system.

Given the suc­cess of our rat­ing sys­tem for indi­vid­ual stocks, we believe its appli­ca­tion to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buy­ing deci­sions. Barron’s reg­u­larly fea­tures our unique ETF research.

Source: Bad and Ugly Materials Sector ETFs