Best And Worst ETFs (And Mutual Funds): Industrials Sector

The Industrials sector ranks fourth out of the ten sectors as detailed in my sector roadmap. It gets my Neutral rating, which is based on aggregation of ratings of 17 ETFs and 18 mutual funds in the Industrials sector as of July 11, 2012.
 
Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Industrials sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 20 to 368), 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 Industrials 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.
 
Investors should not buy any Industrials 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.
 
Figure 1: ETFs with the Best & Worst Ratings – Top 5


Sources: New Constructs, LLC and company filings
 
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 Industrials ETFs and mutual funds, as none of the ETFs or mutual funds are worthy of buying. Investors seeking exposure to the Industrials sector are better off focusing on individual stocks.
 
Northrop Grumman Corp (NOC) is one of my favorite stocks held by Industrials ETFs and mutual funds and earns my Very Attractive rating. NOC is a cash-generating machine. Since 2009, NOC has generated at least $2.6 billion in free cash flow (FCF) each year. And yet the market has an extremely pessimistic view of NOC. Based on its current stock price (~$63.08) the market expects NOC after-tax cash flows (NOPAT) to permanently decrease by 50%. These low expectations offer investors a great risk/reward tradeoff.
 
GEO Group, Inc. (GEO) is one of my least favorite stocks held by Industrials ETFs and mutual funds and earns my Very Dangerous rating. Unlike NOC, GEO is a value destroyer. GEO has generated negative economic earnings every year since 2000 and negative free cash flow (FCF) nine of the past ten years. To justify its current stock price (~$23.11), GEO must increase profits 6.1% annually for 27 years. Lofty expectations and poor performance are the reasons I’m bearish on GEO.
 
429 stocks of the 3000+ I cover are classified as Industrials stocks, but due to style drift, Industrials ETFs and mutual funds hold 518 stocks.
 
Figures 4 and 5 show the rating landscape of all Industrials ETFs and mutual funds.
 
Figure 4: Separating the Best ETFs From the Worst ETFs

Sources: New Constructs, LLC and company filings

Figure 5: Separating the Best Mutual Funds From the Worst Mutual Funds

Sources: New Constructs, LLC and company filings

Disclosure: I receive no compensation to write about any specific stock, sector or theme.