Best & Worst ETFs & Mutual Funds January 2013: Materials Sector

The Materials sector ranks sixth out of the ten sectors as detailed in my Sector Rankings for ETFs and Mutual Funds report. It gets my Neutral rating, which is based on aggregation of ratings of 10 ETFs and 15 mutual funds in the Materials sector as of January 25^th, 2013. Prior reports on the best & worst ETFs and mutual funds in every sector are here.

Figure 1 ranks from best to worst the nine Materials ETFs that meet our liquidity standards and Figure 2 shows the five best and worst-rated Materials mutual funds. Not all Materials sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 30 to 156), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Materials sector, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Materials ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this sector on my free mutual fund and ETF screener.

* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

PowerShares Dynamic Basic Materials (PYZ) is excluded from Figure 1 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

ICON Funds: ICON Materials Fund (ICBMX, ICBCX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Materials Select Sector SPDR (XLB) is my top-rated Materials ETF. Vanguard World Funds: Vanguard Materials Index Fund (VMIAX) is my top-rated Materials mutual fund. Both earn my Neutral rating.

SPDR S&P Metals & Mining ETF (XME) is my worst-rated Materials ETF and Rydex Series Funds: Basic Materials Fund (RYBMX) is my worst-rated Materials mutual fund. Both earn my Dangerous rating.

Figure 3 shows that 41 out of the 225 stocks (over 31% of the total net assets) in the sector get an Attractive-or-better rating. However, none of the 10 ETFs and none of the 15 mutual funds in the Materials sector get an Attractive-or-better rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Materials ETFs hold poor quality stocks.

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Materials ETFs and mutual funds, as no ETFs or mutual funds in the Materials sector allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Focus on individual stocks instead.

CF Industries Holdings, Inc. (CF) is one of my favorite stocks held by Materials ETFs and mutual funds and earns my Very Attractive rating. CF is a consistently strong performer, with 22% revenue CAGR and a 36% economic earnings margin over the past five years. Its valuation has increased over that time, but not enough to keep up with profit growth. At ~$228/share the current price to economic book value ratio is 0.6, which means the market expects a permanent 40% decline in CF’s net operating profit after tax (NOPAT). Those expectations are low for a company with such a strong profit growth track record.

Rowan Co Pic (RDC) is one of my least favorite stocks held by Materials ETFs and mutual funds and earns my Very Dangerous rating. RDC is performing poorly by traditional metrics as well as by our economic or cash-flow-based metrics. Revenue declined last year by 48%. Even worse, RDC’s NOPAT declined by a whopping 78%, bringing ROIC down to barely over 1%. RDC has earned negative economic earnings for the past five years. Nothing in its recent history suggests it will turn around its performance and justify its current valuation, which implies 18% CAGR in NOPAT for 16 years.

165 stocks of the 3000+ I cover are classified as Materials stocks, but due to style drift, Materials ETFs and mutual funds hold 225 stocks.

Figures 4 and 5 show the rating landscape of all Materials ETFs and mutual funds.

Our Sector Rankings for ETFs and Mutual Funds report ranks all sectors and highlights those that offer the best investments.

Review my full list of ratings and rankings along with reports on all 10 ETFs and 15 mutual funds in the Materials sector.

Sam McBride contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector or theme.