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We rec­om­mend investors avoid or sell all indus­trial sec­tor ETFs. We also rate the invest­ment merit of the top six indus­trial sec­tor ETFs.

Per our first-quarter-2011 review of U.S. Equity Sec­tor ETFs, the indus­trial sec­tor is one of five sec­tors that gets our “neu­tral” rat­ing. Per Fig­ure 2, the indus­trial sec­tor allo­cates 50% of its value to neutral-rate stocks with its remain­ing value split fairly evenly between attractive-or-better (22%) and dangerous-or-worse-rated (27%) stocks.

Some good stocks in the indus­trial sec­tor to buy indi­vid­u­ally or as part of an ETF are United Par­cel Ser­vice (NYSE:UPS), 3M (NYSE:MMM), Oshkosh Cor­po­ra­tion (NYSE:OSK) and Cubic Cor­po­ra­tion (NYSE:CUB). Some stocks to avoid, sell or short in the indus­trial sec­tor are Fed­eral Express (NYSE:FDX), Tyco Inter­na­tional (NYSE:TYC) and Eaton Cor­po­ra­tion (NYSE:ETN).

Investors eye­ing indus­trial sec­tor ETFs should be care­ful. The sec­tor offers stocks with both good and bad invest­ment poten­tial. The invest­ment merit of each ETF derives from its con­stituents, so ETFs that over­weight attractive-or-better-rated stocks, like MMM and UPS, can be great invest­ment oppor­tu­ni­ties while ETFs that over­weight neutral-or-worse-rated stocks, like FDX and ETN, should be avoided.

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

(Click charts to expand)

Sources: New Con­structs, LLC and com­pany filings

When ana­lyz­ing the indus­trial sec­tor ETFs, we started by iden­ti­fy­ing those ETFs with accept­able struc­tural integrity as mea­sured by XTF, an ETF research firm. We chose the 6 ETFs whose XTF rat­ing was above the sec­tor aver­age XTF rating.

Fig­ure 2: Indus­trial ETFs With Accept­able Struc­tural Integrity

Sources: New Con­structs, LLC; XTF and com­pany filings

Fig­ure 2 shows clearly that not all indus­trial 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 indus­trial 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 indus­tri­als ETFs.

Neu­tral ETFs:

DIA, PPA, XLI, IYJ and VIS allo­cate the value of their funds in a way that earns them a neu­tral rat­ing. We rec­om­mend investors buy the very attrac­tive and attrac­tive stocks in this sec­tor before buy­ing any of the indus­tri­als ETFs we cover in this report. Con­tact us for the full list of the 57 indus­tri­als com­pa­nies that earn an attractive-or-better rating.

Dan­ger­ous ETFs:

We rec­om­mend investors avoid or sell short IYT because of its dan­ger­ous rating.

Bench­mark Comparisons: Sec­tor Benchmark

DIA out­per­forms the over­all indus­tri­als sec­tor in qual­ity of earn­ings rat­ings. Both DIA and the sec­tor earn very attrac­tive eco­nomic vs. reported earn­ings rat­ings because their eco­nomic earn­ings are pos­i­tive and ris­ing. DIA earns an attrac­tive ROIC rat­ing with an ROIC of 11.8% com­pared with the sector’s ROIC of 9.2%.

DIA also out­per­forms the sec­tor in val­u­a­tion rat­ings. DIA has a GAP of 17 years, earn­ing it a neu­tral rat­ing, and a price-to-EBV of 1.1 com­pared to the over­all sector’s GAP of 31 years and price-to-EBV of 1.5.

Fig­ure 4: DIA – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 5: Indus­tri­als Sec­tor – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

DIA more effec­tively allo­cates cap­i­tal than the over­all indus­tri­als sec­tor. Per Fig­ure 3 above, DIA allo­cates 60.7% of its value to attractive-or-better-rated stocks while the sec­tor only allo­cates 22.7%. DIA also only allo­cates 16.4% of its value toward Dangerous-or-worse-rated stocks com­pared to the sector’s dangerous-or-worse weight­ings of 27.5%.

Bench­mark Comparisons: Market Benchmark

The S&P 500 (NYSEARCA:SPY) out­per­forms DIA in qual­ity of earn­ings rat­ings. The S&P 500 and DIA earn very attrac­tive eco­nomic vs. reported earn­ings rat­ings because their eco­nomic earn­ings are pos­i­tive and ris­ing. The S&P 500 earns a very attrac­tive ROIC rat­ing with an ROIC of 18.3% com­pared to DIA’s ROIC of 11.8%.

DIA out­per­forms the S&P 500 in val­u­a­tion rat­ings. DIA has a GAP of 17 years, earn­ing it a neu­tral rat­ing, and a price-to-EBV of 1.1 com­pared with the S&P 500’s dangerous-rated GAP of 24 years and price-to-EBV of 1.4.

Fig­ure 6: DIA – 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

DIA more effec­tively allo­cates cap­i­tal than the S&P 500. Per Fig­ure 3 above, DIA allo­cates 60.7% of its value to attractive-or-better-rated stocks while the S&P 500 only allo­cates 42.3%. DIA also only allo­cates 16.4% of its value toward dangerous-or-worse-rated stocks com­pared with the S&P 500’s dangerous-or-worse weight­ings of 23.7%.

Method­ol­ogy

This report offers rec­om­men­da­tions on Indus­tri­als sec­tor ETFs and bench­marks for (1) investors con­sid­er­ing buy­ing indus­tri­als sec­tor ETFs and for (2) com­par­ing indi­vid­ual ETFs to the indus­tri­als 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 (429 com­pa­nies) based on data as of April 19th, 2011. 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, an ETF research firm, to find the top six ETFs with the best struc­tural integrity rating.

2) The qual­ity of the ETF’s hold­ings. We deter­mine an ETF’s qual­ity using our stock ratings.

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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.