XLB: Strong Investment Case Still Present

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Main Thesis & Background

The purpose of this article is to discuss the Materials Select Sector SPDR ETF (NYSEARCA:XLB) as an investment option at its current market price. This is a sector I don’t cover too often, but I have spoken positively about it since the pandemic started. Fortunately, it has held up reasonably well on a relative basis compared to the market. For perspective, I last covered XLB roughly a year ago, when I slapped a buy rating on the fund. Looking back, this would have been a good investment. While a lot has happened between June 2021 and June 2022, the total return of XLB speaks for itself:

1-Year Fund Performance (Seeking Alpha)

As I look ahead to the second half of the year, I am understandably nervous as I’m sure most investors are. The world appears to be getting less stable, and inflation and rising interest rates are both pressuring the outlook for stocks. However, markets have corrected a good bit, so we can take comfort in knowing that the frothy equity levels we started the year with are not the reality anymore. Furthermore, there is always value somewhere, and I think the Materials and Chemicals sectors, and XLB by extension, offer some of that value. I see the potential for more gains going forward, and will explain why in detail below.

Inflation Has Been A Sore Point, But Less So For Materials

To begin, I want to emphasize one of the primary reasons for the volatility in the market. This is inflation – which should not be a shock to anyone. In fairness, inflation has been around for a while, but market participants were not taking it seriously enough in most of 2021 because the idea was that inflation would be “transitory”. I honestly don’t know where that attitude came from, it was more wishful thinking than an analysis of reality. Nevertheless, I suggested readers consider XLB last year on the basis that inflation would be persistent and this sector should outperform. That indeed turned out to be the case, on both fronts. XLB did best the S&P, and inflation has decidedly not slowed down at all in 2022:

Cost of Living Soaring (Yahoo Finance)

So, why is this important? The simple answer is that inflation does not treat all sectors equally. This is why in this environment being a more selective investors can really come in handy. The S&P 500, for example, is very Tech-heavy. And Tech happens to be a sector that struggles under an inflationary environment. Others, like Consumer sectors and Utilities, face similar challenges.

By comparison, areas like Energy and Materials often perform better than average. This is because the value of the products these sectors harvest, produce, refine, or manufacture become more valuable when there is scarcity and prices are rising. This helps to justify expectations that Materials is going to see strong EPS growth this calendar year, near the lead of the pack:

Estimated EPS 2022 (FactSet)

My thought here is that XLB as an investment remains as viable as it has at any point since my 2021 buy rating. The sector has proven it is more resilient than the broader market in a difficult climate, and its estimated earnings are expected to be strong. Given this data, I see support for maintaining my bullish outlook.

XLB Has A Slight Discount To The Market

Another reason for considering XLB has to do with valuation. Personally, I would be considering this ETF even if the fund was priced higher than the S&P 500. This is because I see inflation continuing, which is a tailwind for Materials in relative terms. Further, any P/E gap would narrow if earnings estimates turn out to be accurate (since EPS are expected to rise for Materials faster than the S&P 500 as a whole). However, XLB is actually cheaper than the S&P 500, which a current P/E just over 17, compared to the S&P’s, which is over 19:

P/E for XLB (State Street)

P/E for S&P 500 (Multpl.com)

For me this represents a bit of a no-brainer. XLB has multiple headwinds, and it is attractively priced. I see this valuation story as supportive of my view.

Chemicals Exposure Is Important

I now want to dig in to the underlying make-up of XLB. While it has “materials” in the name, that can mean quite a bit of different things. In the case of this particular fund, it actually means a lot of exposure in the Chemicals sub-sector. In fact, this is by far the most important component of this fund:

XLB Composition (State Street)

I want to highlight this because it is consistent with how the fund was composed last year as well. The Chemicals industry has had a reasonable run, but investors need to anticipate that continuing if they want to make a play on this “materials” fund.

One area I see contributing to growth for this sector is the automotive industry. This is an area that has been short on supply since mid-2021. Auto sales have been slowing in 2022 as a result. However, we do not invest based on what has been happening in the last few months, but what is expected to happen in the future. Given how weak sales have been, it is logical to suggest brighter days lie ahead. With prices still elevated and consumers in a tight spot, I would suggest we are going to see more production as retailers will want to capitalize on historically high prices but also get more inventory on the lot to reach more customers. With inventory tight, this gives manufacturers plenty of incentive to ramp up production and do whatever they can to increase capacity. Yes, there are production constraints caused by shortages in inputs and workers, but I see this stabilizing in the second half of the year and into 2023 as well.

This is relevant to this investment idea because chemicals companies supply chemicals for many of the automotive applications found in modern cars:

Chemicals’ Relevance to Cars (McKinsey & Co.)

This is probably one of the key reasons why industry analysts are anticipating another strong year for the chemicals trade in 2022. After we saw a ton of growth last year, the American Chemistry Council (ACC) sees compounding growth for this calendar year as well:

Chemicals Exports/Imports (Yahoo News)

My conclusion here is the outlook for the Chemicals sector is pretty bright. Given XLB’s overweight exposure to this arena, I see it as a tailwind for performance going forward.

Infrastructure Demands Material Inputs More Broadly

My final point looks at materials as an investment theme more broadly. This is relevant for chemicals, sure, but also for other inputs like steel, copper, minerals, and a host of other commodities which should see higher demand and prices in the near term. Since late last year, major infrastructure spending was passed in the U.S. Congress. These projects have been slow to get off the ground as a whole, which offers opportunity in the coming months even though legislation was in the past. For perspective, consider the Infrastructure Investment and Jobs Act signed into law last year provided $1.2 trillion in government spending for a variety of projects:

Ongoing and Future Infrastructure Projects (U.S.) (Fidelity)

These projects and countless others will drive demand for material inputs in the years to come because, let’s face it, construction and infrastructure projects take time, go over budget, and are slow to get off the ground.

On a related note, I would suggest that prices (and profits) for this sector are influenced by more than just public works in America. Global demand for infrastructure needs will push input prices higher as well, benefiting the firms that produce and sell these inputs. And there are catalysts right now that support a bullish outlook for global works.

Take the current conflict in Ukraine. According to the Wilson Center, the cost of Russia’s invasion is expected to exceed $1 trillion (as of now). Regardless of the outcome and who controls the territory, there is going to have to be massive rebuilding efforts in that region. While the Ukrainian (or Russian) governments may not have the resources to tackle these projects on their own or right away, there have already been international commitments from developed nations within the EU and the United States to support this reconstruction. This is good news on a humanitarian level, and also a tailwind for funds like XLB.

Bottom Line

2022 has taught us that getting creative can pay off. The S&P 500 and other major indices are down for the year. Yet some sectors are up – such as Energy and Utilities. Other, like Materials, may be down year-to-date but they are suffering much less than other discretionary areas. The key theme here is that sectors that are moderate inflation hedges and/or exposed to commodities and other input materials are out-performing. This is interesting because these are also the sectors that are barely represented within the S&P 500 index. So investors who want this exposure have to branch out beyond just large-cap U.S. stock funds. This brings me to XLB, which is a play on chemicals and materials companies and has locked in a gain over a difficult 1-year period. As we push deeper into 2022, I see this trend continuing. As a result, I will be looking to initiate a position in this fund, and suggest readers give the idea some consideration at this time.