iShares Consumer Services Bucks Downward Trends, for Now

With AIG (AIG), Lehman Brothers (LEH) and Merrill Lynch (MER) dominating the financial headlines to start the week, the economic outlook seemed to grow bleaker yet again, and those who have been skeptical about consumer spending—for months now, even years—seemed to gather more ammunition.

How this Black Sunday works itself out remains to be seen, but so far in this economic slowdown, iShares Dow Jones U.S. Consumer Services (IYC) has held up well and may offer some value whenever recovery takes hold.

Through Sept. 12, IYC ranked among the top 1% of Large Growth ETFs for one-month (0.0%), three-month (-0.1%), and year-to-date (-4.6%) returns, holding a nearly nine-percentage-point lead over the S&P 500 for 2008. In fact, of the 12 major stock sectors tracked by Morningstar, the consumer services sector is the only one with a positive return over the year-to-date (3.3%) and one-year (4.5%) periods. The fund moved up 18 spots on our ETF Momentum Tracker Sector Momentum Table in recent weeks, from No. 29 to No. 11, prior to last weekend’s news.

IYC offers a very broad 222-stock mix, with many names from two more common sector funds/ETFs: those that track consumer staples and those that track consumer discretionary. Morningstar analyst Emiko Kurotsu noted recently that by sharing key holdings with both types of funds, IYC offers some of the best of both worlds, though “investors don’t get as much bang for their buck as they would in a higher-quality consumer-staples fund.”

In short, the fund’s portfolio consists entirely of shares of companies that vie for the portion of consumers’ paychecks that’s left over after paying all fixed costs—but also cashes in on necessities such as food, health and beauty aids, and clothing.

The top holding, Wal-Mart Stores (WMT), offers an example of a firm that’s done well in a tough economy. The massive chain offers shoppers a mix of staples and discretionary items, keyed by low prices. Wal-Mart beat expectations with a 17% second-quarter rise in net income and an increased earnings forecast that seemed to cheer up investors.

Shares of Wal-Mart, which make up more than 10% of the fund’s portfolio, are up 30.6% year to date, 24.6% in the last six months, and 4.5% over the last month, as the giant retailer keeps plugging away, aided in part by the federal tax rebate earlier this year. Wal-Mart also captured many customers “trading down” from more expensive stores, thanks to low prices and an emphasis on such items as flat-screen TVs, apparel, and home fashions.

No. 2 holding McDonald’s (MCD) has also survived nicely in 2008. Analysts downgraded many U.S. restaurant stocks because of economic weakness in the United States, cost pressures, early signs of slowing business in Europe, and a stronger U.S. dollar, but McDonald’s has kept chugging along. The company has beaten its peers in terms of driving customer traffic and containing commodity costs, with same-store global sales up 8% in July and 8.5% in August. Share prices are up nearly 9% year to date and 7.1% in the last three months.

Only four other stocks make up more than 3% of the IYC portfolio, prompting Kurotsu to call it “the best diversified consumer ETF by number of holdings and subsectors.” That broad mix of staples stocks (discount stores, supermarkets) and more discretionary stocks (leisure, specialty retail, Internet retail, and a few tied to automotive or luxury-product firms) gave the fund a three-year standard deviation of 11.41 that’s just slightly higher than the S&P 500.

IYC targets the largest consumer stocks, recognizable names that have led to an average market capitalization of more than $21 billion, with just less than 70% of assets in stocks rated large- or giant-cap. And big companies can benefit from global growth during tough times at home.

The fund is a true large-growth offering, despite the dearth of smaller stocks. IYC’s average holding recently boasted a long-term earnings growth forecast of 14.1% per year, roughly 30% greater than that of the average stock in the S&P 500.

The fund is also undervalued by almost 15%, according to Morningstar, which on Sept. 12 set IYC’s fair value estimate at $68.63, compared to the market price of less than $59. The fund’s price-to-prospective earnings ratio is 15.3, about 10% higher than the S&P 500’s.

If the latest economic news, including the AIG, Lehman and Merrill bombshells, turns out to be a sign of a continually weakening economy—especially on a global scale—the job market and consumer spending could go down with the ship and take IYC with it.

Still, many economists and analysts have been questioning the strength of the consumer for years, both at home and abroad. Shareholders would be wise to keep an eye on Wall Street’s view of consumer spending, but IYC has survived some difficult times and appears well-poised for a future recovery.