PYZ: Can This Highly Cyclical Materials ETF Keep the Good Times Rolling?

by: Don Dion

PowerShares Dynamic Basic Materials (NASDAQ:PYZ) was born at the right time. PYZ debuted on Oct. 12, 2006, just in time to catch a rising tide in the sector, driven by global growth, industry consolidation, and even a weakening dollar.

The ETF’s NAV is up 39.5% since inception (through Oct. 8), compared with a 14% gain for the S&P 500. And the fund has only accelerated over the last month, as investors look to minimize the threat of a U.S. slowdown to their portfolios and pile into firms with major international business.

Last month’s interest-rate cuts helped raise expectations for continuing worldwide growth and demand for materials. At the same time, the weak dollar has pushed investors toward American firms with significant overseas operations. The dollar’s drop helps lift profits from abroad while allowing U.S. firms to stay competitive against international companies.

As a result, materials topped the 10 economic groups in the S&P 500 for September with a 7.65% gain.

Over the last month (through Oct. 8), shares of PYZ’s top 10 holdings all rose, led by No. 1 Monsanto’s (NYSE:MON) 25.6% one-month gain. The ETF’s top 10 holdings averaged a one-month jump of 15.78%. All 10 are also up year to date by an average of 58.58%. Going back one year, three stocks — Freeport-McMoRan Copper & Gold (FCU), Mosaic (NYSE:MOS), and Southern Copper (PCU), the second- through fourth-largest holdings—more than doubled, while the top 10 stocks had an average gain of 81.7%.

We added PYZ to the PowerShares Momentum TrackerPortfolio on Oct. 4, after the ETF climbed to No. 8 on the Sector Momentum Table. Since we added the ETF to the newsletter ranking in February, the fund has remained in the top 10 for all but one week in mid-September. Between February and mid-August, the materials sector was represented by FTSE RAFI Basic Materials (PRFM) in the portfolio.

PYZ invests across the materials sector, focusing on the stocks of companies that produce and distribute chemicals, metals, plastics, and paper. They tend to do well during times of strong economic growth, because a rise in demand for their products lifts prices and profit margins.

Over the past few years, demand from China and other rapidly growing, emerging economies has aided the sector. Now, economic resurgence in Western Europe and Japan is helping too. Though the effect of a U.S. slowdown on global growth is debated among economists and analysts, many firms in this space remain well positioned for the long haul.

The ETF experienced a sharp pullback after hitting all-time highs in July, with its NAV falling 16.3% from July 19 to Aug. 16. Broader markets also slipped at the time on the subprime crisis and credit crunch, but the materials sector and PYZ fell much further. The fund quickly regained its footing and climbed to within a whisker of its 52-week high this week.

After a long run-up, top holding Monsanto, which dominates the agricultural seed business, raised its outlook in September, boosting shares to all-time highs. The stock is up 67.1% year to date, and more than 1,100% in the past five years. The company cited rising demand and prices for corn, aided by the move toward ethanol-based biofuels, as a driver for Monsanto’s growth. Also last month, Monsanto announced a deal with Dow Chemical (DOW) to develop a new genetically enhanced corn seed to repel weeds and insects.

No. 2 holding Freeport-McMoRan and No. 4 Southern Copper gained from a strong rise in copper prices, which are up more than 31% this year, and resurgent gold prices. Freeport also attracted investors with its savings from its $26 billion acquisition of Phelps Dodge.

Mosaic, a provider of raw materials used by the agriculture industry and PYZ’s No. 3 holding, reported a surge in earnings Oct. 9 that sent shares climbing again, even after the stocks gained 140.5% year to date (through Oct. 8).

U.S. Steel (NYSE:X) (shares up 44.2% year to date) announced the $1.1 billion acquisition of Canadian competitor Stelco, just a few months after completing the $2.1 billion purchase of Lone Star Technologies.

Like many companies in the materials sector, U.S. Steel is planning more acquisitions. Mergers and acquisitions in the sector have helped drive up stock prices, with many companies’ shares still getting a boost from takeover speculation.

Despite all the good news, investors here should be aware of a few potential negatives for this fund. First, the materials sector has a long history of cyclical performance. Stocks tend to fall hard when demand (and prices) fall, often because of a slowdown.

With uncertainty surrounding the U.S. economy, investors have piled into materials. But some analysts warn of sky-high valuations after such a run-up, making bargains rare and increasing the chances of a potentially painful pullback if there were any signs of a global slowdown. If global growth stays strong, however, a small dose of PYZ could help a balanced portfolio.