Choosing Consumer Discretionary Sector ETFs Requires Discretion

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 |  Includes: PBS, RTH, VCR, XHB, XLY, XRT
by: David Trainer

Retail HOLDRS (NYSEARCA:RTH) is our top pick for con­sumer dis­cre­tionary sec­tor ETFs. RTH is one of 51 ETFs that gets an attractive-or-better rat­ing. We rate the invest­ment merit of the top six con­sumer dis­cre­tionary sec­tor ETFs based on our cov­er­age of 471 stocks in this sector.

Per our first-quarter-2011 review of U.S. Equity Sec­tor ETFs, the con­sumer dis­cre­tionary sec­tor is one of three sec­tors that gets our “attrac­tive” rat­ing. Per Fig­ure 2, the con­sumer dis­cre­tionary sec­tor allo­cates 34% of its value to stocks with an attractive-or-better rat­ing. 26% of its val­ues goes to dangerous-or-worse-rated stocks.

Some good stocks in the con­sumer dis­cre­tionary sec­tor to buy indi­vid­u­ally or as part of an ETF are McDon­alds (NYSE:MCD), Ford (NYSE:F), Nike (NYSE:NKE) and Tar­get (NYSE:TGT). Some stocks to avoid, sell or short in the con­sumer dis­cre­tionary sec­tor are Dis­ney (NYSE:DIS), CBS Corp (NYSE:CBS), Net­Flix (NASDAQ:NFLX) and Star­wood Hotels & Resorts World­wide (NYSE:HOT).

Though the con­sumer dis­cre­tionary sec­tor offers many stocks with strong invest­ment poten­tial, not all ETFs can be trusted. Investors must assess the mer­its of each ETF based on its con­stituents. Per Fig­ure 3, there are sev­eral ETFs to avoid in this sec­tor.

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


Sources: New Con­structs, LLC and com­pany filings

(Click charts to enlarge)

When ana­lyz­ing the con­sumer dis­cre­tionary 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: Con­sumer Dis­cre­tionary ETFs With Accept­able Struc­tural Integrity


Sources: New Con­structs, LLC; XTF and com­pany filings

Fig­ure 2 shows clearly that not all con­sumer dis­cre­tionary 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 con­sumer dis­cre­tionary 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:

RTH is the only con­sumer dis­cre­tionary ETF to earn an attrac­tive rat­ing and, there­fore, is the only con­sumer dis­cre­tionary ETF we recommend.

Neu­tral ETFs:

XLY, VCR, PBS, and XRT 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 con­sumer dis­cre­tionary ETFs except RTH.

Dan­ger­ous ETFs:

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

Bench­mark Comparisons Sec­tor Benchmark

RTH’s rat­ings are the same as the over­all sector’s rat­ings, except for price-to-EBV and growth appre­ci­a­tion period ((GAP)). RTH has a sig­nif­i­cantly shorter GAP than the over­all sec­tor (11 years ver­sus the sector’s 29-year GAP), earn­ing it a neu­tral rat­ing. How­ever, RTH has a higher price-to-EBV com­pared with the sec­tor (1.5 ver­sus the sector’s 1.1 Price-to-EBV).

Fig­ure 4: RTH – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 5: Con­sumer Dis­cre­tionary Sec­tor – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

RTH more effec­tively allo­cates cap­i­tal than the over­all con­sumer dis­cre­tionary sec­tor. Per Fig­ure 3 above, RTH allo­cates 42% of its value to attractive-or-better-rated stocks while the sec­tor only allo­cates 36%. RTH also allo­cates none of its value toward dangerous-or-worse-rated stocks com­pared with the sector’s dangerous-or-worse weight­ings of 26%.

For expla­na­tion and details behind our risk/reward rat­ing sys­tem, see one of our com­pany val­u­a­tion reports, avail­able for free here.

Mar­ket Benchmark

RTH out­per­forms the S&P 500 (NYSEARCA:SPY) in val­u­a­tion rat­ings. RTH earns an attrac­tive free-cash-flow yield rat­ing com­pared to the S&P 500’s neu­tral rat­ing. RTH also has a neu­tral GAP rat­ing com­pared to the S&P 500’s dan­ger­ous GAP rating.

RTH has sim­i­lar qual­ity of earn­ings rat­ings com­pared to the S&P 500. RTH’s market-weighted ROIC of 11.8% earns it an attrac­tive rat­ing while the S&P 500’s market-weighted ROIC of 18.3% earns it a very attrac­tive rating.

Fig­ure 6: RTH – 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

RTH allo­cates cap­i­tal more effec­tively than the S&P 500. Per Fig­ure 3 above, RTH allo­cates none of its value to dangerous-or-worse-rated stocks while the S&P 500 allo­cates 24%. RTH and the S&P 500 sim­i­larly allo­cate cap­i­tal to attractive-or-better-rated stocks.

Method­ol­ogy

This report offers rec­om­men­da­tions on con­sumer dis­cre­tionary sec­tor ETFs and bench­marks for (1) investors con­sid­er­ing buy­ing Con­sumer Dis­cre­tionary sec­tor ETFs and for (2) com­par­ing indi­vid­ual ETFs to the Con­sumer Dis­cre­tionary 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 (471 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:

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.

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

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