Taking a Closer look at Sub-sector ETFs in 2013: Part 1

by Wayne Ferbert on January 7th, 2013

As promised, we said we would examine the largest ETFs that track sub-sectors to see if we can find any valuation opportunities in 2013. We know we like Financials and Energy at the sector level in 2013. But a pocket inside an industry can offer an opportunity if it is trading at the right discount.
In our introduction article, we listed the largest sub-sectors that have an ETF over $100 million in market capitalization. We will tackle three sub-sectors at a time until we get thru the entire list. In today’s article, we look at Agriculture, Real Estate, and Metals/Mining companies.
1. Agriculture ETFs
In Agriculture, there are two Agribusiness ETFs that have a market cap over $100 million: MOO and PAGG. MOO is quite large with over $5 billion in AUM but PAGG is only $100 million. The holding of both are similar.
The top names in this category are Monsanto, Syngenta, Potash, Deere, Archer-Daniels Midlands, Agrium, & Mosaic. When we examine the stocks that make up 80% of the total AUM within these ETFs, we don’t find many values. In fact, when you examine the multiples in this space and the Morningstar ratings, we find very few buys. Archer Daniel Midlands and Mosaic are the only two companies that have even attractive valuations – and they are not the largest companies in the space. The largest of the large cap in this space all appear fairly valued.
So, for now, the Agriculture space does not look like a buy in 2013.
2. Real Estate ETFs
Moving on to the Real Estate sub-sector, we can really examine the largest ETF in this space: the IYR from iShares. It is the Dow Jones U.S. Real Estate ETF. This ETF is fairly diversified. To include all of the stocks in this ETF that make up 80% of its total market capitalization, you need to include the largest 42 stocks within this ETF. That is a lot.
The top names you might recognize in this ETF are the Simon Property Group, American Tower, and Public Storage. But these companies have already had a solid year in 2012 as the sub-sector beat the S&P 500 by about 2% already.
When we examine the largest 40 companies in this sub-sector ETF, we find only ONE stock that our valuation system would rate as a buy. That was Annaly Capital (NLY). Morningstar only rates two of the top 40 as buys. These are not good odds for 2013. This sub-sector looks fairly valued. In fact, based on these ratings, I would expect this sub-sector to under-perform the broader market in 2013 – though not by a lot.
3. Metals and Mining ETFs
The last sub-sector we will examine today is Metals and Mining. There are A LOT of mining ETFs. Mining has become a popular sub-sector with active traders and speculators. But we are looking for valuation opportunities over the long term – not a quick buck.
We will tackle the more traditional Metals and Mining group in today’s article – and look to cover the Gold Miners in a later sub-sector analysis.
There is the XME which is the S&P 500 mining AND metals ETF. It is more dominated by metals than by mining companies.
This ETF actually has several well known companies in it: Allegheny Technologies, Cliffs, AK Steel, and Reliance Steel are the top four holdings. But combined, they only equal 14% of the total AUM in this fund. This fund is significantly diversified across many holdings. There are 38 stocks inside it and it takes 24 of them to make up 80% of the total AUM. And no stock is more than 3.6% of the total holdings.
That means that to form a strong opinion on this sub-sector, we need to feel good about MANY of the stocks in this portfolio in this ETF. Of the top 24 holdings, 11 of them would get a Buy rating on our valuation system. Only 5 of them would get a Sell rating and the remaining 8 would be Holds.
When you look at a sub-sector with that kind of distribution, it would most likely be a Buy candidate. So, let’s look closer. Of the top 24 holdings, 14 of them have a Morningstar Rating. 9 of the 14 get a Buy Rating with 4 or 5 stars. One of them gets 2 stars as a Sell and the rest are rated 3 stars.
Again, the Morningstar rating at the individual stock level looks fairly good.
But taking a closer look, Morningstar rates the entire ETF (IYR) as a 1 star ETF. That rating means DON’T BUY and RUN FOR THE HILLS. The reason: these stocks, while they have potential for good returns, are VERY volatile. Over the last 2 years, this ETF has had more than TWICE the volatility of the broader S&P 500. That is significant for a fund with 38 stocks in it.
The metals and miners are volatile because it is really a commodity play and commodity prices have been volatile world-wide in 2012. On top of that, these players are all LIMITED to the US since it is a S&P index ETF. World wide, the US Miners and metal companies are not the largest most promising players. In other words, they are at a competitive disadvantage against larger players. So, Morningstar gives them a weak rating.
I would have to err on the side of caution here. While the underlying stocks certainly look under-valued, the overall nature of this industry for US companies is that of tier-2 players. We want to invest in best of breed mega-cap players with built in advantages. The companies inside this ETF will never be mistaken for strong players in the global competition in this space.
As a result, we will pass on Metals and Mining in the US.
So, we examined three sub-sectors and found no potential investment opportunities. That is OK. Remember that the investments you choose to PASS on are as important as the ones you choose to invest in.
Next time, we will look at Homebuilders, Bio-Technology, and Banks. These will certainly be a more interesting group to examine! 

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