Industrial-sector-funds could boost your bottom line

You’ll be forgiven for thinking that the industrial sector isn’t all that different from the U.S. economy at large. After all, the nation’s venerable stock index, the Dow Jones industrial average, still uses the word “industrial” more than a century after its 1896 inception. But in 2014, the index of 30 companies that make up the Dow contains only five industrial names, representing only about 13 percent of its value. And industrials—which include electrical equipment and machinery, and a significant amount of transportation-related funds—make up only 11 percent of the broader Standard & Poor’s 500 index.

Although there’s a high correlation between industrial-sector stocks and the S&P 500, those industrial stocks don’t merely mirror the behavior of the broader market but amplify it. That trend is captured in a statistical measure known as the standard deviation, which measures the volatility of a stock, or group of stocks, vs. the movement of the overall market. The 10-year standard deviation of industrial stocks is currently 18.7, which indicates that they tend to move 25 percent more in price (up or down) than the broader market, which has a standard deviation of 14.7. In good times, industrials can lead the pack. Conversely, they tend to lag behind other sectors just before and during economic recessions.

We don’t expect the latter to happen anytime soon. After years of industrials generally underperforming the broader market, there are indications that we may see a continuation of the industrial outperformance that began in 2010.

It might seem that this sector is particularly vulnerable to shifts in the global economy that have moved U.S. factories to Mexico and Asia. But although our economy has indisputably become more global in nature, the U.S. still plays a significant role in manufacturing, one that continues to grow.

Captains of industry

The no-load funds and ETF below primarily own U.S.-based industrial stocks.

Data: Morningstar. Annualized returns and expense ratios as of Feb. 28, 2014.

A newfound competitiveness in manufacturing has prompted what the business world is calling the “U.S. manufacturing renaissance.” That competitiveness isn’t due to a single factor but a number of them, each resulting in a cost savings for industrials here in the U.S. Three of the major factors include cheap energy (our abundant natural gas, despite the harsh winter, is still relatively inexpensive), a generally cheaper U.S. dollar vs. foreign currencies, and a change in the manufacturing landscape abroad. (Wages in emerging markets such as China have grown in recent years, meaning that outsourcing isn’t as cost effective.)

Industrials are currently cheap in other ways, too. They have been cursed with low earnings expectations for some time, according to some analysts, which have tended to hold down share prices. But yesterday’s curse could prove to be tomorrow’s blessing for investors. Earnings of industrials have been surprisingly stable in the last year, according to research from Bank of America Merrill Lynch. They currently have the most reliable earnings among all 10 economic sectors, even more predictable than the clockworklike earnings of the consumer staples sector. And stable earnings of industrials will eventually be rewarded by the market in the form of increasing share prices.

In addition, the key industrial indicator continues to percolate. According to the Institute for Supply Management, the manufacturing sector (ISM’s term for industrials) has been expanding for nine consecutive months through February, as measured by its purchasing managers index. The PMI measure also remains safely above recessionary levels. With no economic slowdown in evidence, industrials, at least in the short term, should provide investors with at least some near-term opportunities.

You might already have some exposure to the industrial sector if your stock investments are largely in broad market index funds based on the S&P 500, but perhaps not as much as you think. If you want to add a little more industrial strength to your portfolio, consider one of the three funds below. The inexpensive choice would be the S&P Industrial Select Sector SPDR Fund (ticker: XLI), with an expense ratio of just 0.16 percent annually.

This article also appeared in the May 2014 issue of Consumer Reports Money Adviser.