Industrial and materials stocks are highly cyclical sectors of the market and can add a larger amount of volatility to a portfolio.
The stock gains can be large, but these industries are also more sensitive to economic cycles and trade wars.
These sectors are often perceived as the middle of the pack in terms of risk, says Derek Horstmeyer, assistant finance professor at George Mason University in Fairfax, Virginia.
What are industrial and materials stocks?
While industrial and materials stocks have "definitely have shifted upward" from the ongoing trade dispute, more risk lies ahead, Horstmeyer says.
"Even with Phase 1 of the trade deal agreed upon, there still is considerable macro risk inherent in materials and industrials companies," he says. "These firms have exhibited higher than average volatility as compared to the average S&P 500 (.SPX) company and most likely will continue this in the near future."
Industrial stocks are primarily companies that produce or distribute machinery, equipment or supplies used in the manufacturing, construction or defense industries, says Rich Messina, senior vice president, investment product management at E-Trade Financial, a New York-based brokerage company.
"Materials stocks are largely involved in the processing or discovery of raw materials like oil, gold or chemicals," he says. "Most industries, including the industrials sector, rely heavily on materials companies."
The materials sector includes companies that produce intermediate products that can be used throughout various industries to produce other products and include Alcoa Corp. (AA), Archer Daniel Midlands Co. (ADM), DuPont (DD), Dow Chemical Co. (DOW) and United States Steel Corp. (X), says Angelo DeCandia, a business professor at Touro College in New York.
The advantage of adding industrials and materials stocks
These sectors are typically more sensitive to economic cycles – when the economy is flourishing, they tend to outperform, Messina says.
"This makes sense because industrials are the backbone of a strong economy," he says. "They create machines and equipment to produce goods and services."
When global growth stagnates or when geopolitical tensions heat up, these stocks can get caught in the "crossfire of trade tensions," Messina says.
Investors must understand that industrial and materials stocks are highly sensitive to macroeconomic developments, meaning "they tend to move in tandem with the global economy," says Stephanie Lewicky, senior manager of futures and forex at TD Ameritrade, a New York-based brokerage. Their positive correlation to the global economy makes them attractive in a rising growth environment.
"When growth is plentiful, these stocks tend to do well," she says. "Conversely, they are often hit the hardest during downturns. "Boeing (BA) and Caterpillar (CAT) are two large-cap industrial companies that have served as proxies since the start of the U.S.-China trade war."
The benefits of including these sectors can include outsized returns if the investment period is coming out of an economic recession, says Margaret Reid, a senior portfolio manager with The Private Bank at Union Bank. Many of these companies generate consistent cash flow and return cash to shareholders in the form of share repurchases and dividends.
The main reason to hold these stocks is to collect the dividends, but they can also be used to hedge risk, says Anthony Denier, CEO of Webull, a New York-based trading company.
The disadvantage of industrials and materials stocks
These industries can also take a nosedive because when demand slows, deflation is typically an outcome "as companies have to lower prices to compensate for weaker demand and likely excess supply," Reid says.
The result is lower profits and cash for companies to reinvest in their businesses.
"When global economies enter recessions, these companies tend to see more downside volatility in their valuations and earnings as investors flee to safety in their investments," she says. "These areas can also see outsized selling pressure as the economy slows and ultimately enters a recession."
The cyclicality of these stocks is both advantageous and a negative because they are often "some of the first assets shed when recession talk creeps into markets," Lewicky says.
"Depending on the goals of an investor, the higher dividend yields of industrials and materials stocks might be attractive for income generation," she says. "Conversely, sectors like technology or semiconductors have lower dividend yields but typically offer higher returns with similar cyclicality."
Since the start of the U.S.-China trade war in mid-March 2018, the industrials sector has underperformed the benchmark S&P 500 by roughly 5%, while the materials industry has underperformed by 10%, Lewicky says.
"This is directly tied to not only expectations for global growth but also international trade flows," she says. "If an official thawing of tensions occurs, these sectors could see near-term outperformance."
When the economy is weaker or contracting, demand is lower and the sector will underperform while the opposite is also true, says Elizabeth Vermillion, an equity analyst at New York-based CFRA Research.
"Industrial stocks are very exposed to global macroeconomic conditions, tariffs and fluctuating demand," she says. "Since many industrial companies are cyclical, demand for their products and services is directly tied to the economy. Many industrials have a global footprint, which can be beneficial if weakness in some regions is offset by strength in other regions."
Tariffs have dominated the conversation around industrial stocks for the last two years because the ones levied onto the steel and aluminum industries directly impact companies by increasing the price it costs to manufacture products, Vermillion says.
"Tariffs have led to increased input prices that have forced some industrials companies to raise prices on their goods and services," she says. "There are many indirect effects of tariffs which are harder to quantify, but can be equally (if not more) impactful. When companies have to raise prices on products and services, they may face push back from customers that can delay sales and increase project lead times."
How to add industrials and materials stocks to a portfolio
A simple way of gaining exposure to these sectors is through mutual funds and exchange-traded funds such as the Vanguard Materials Index Fund (VAW) and the Industrial Select Sector SPDR Fund (XLI). These funds mirror the sector benchmarks at a relatively low cost, Messina says.
The addition of the S&P 500 as a mutual fund or ETF is common in many portfolios. The industrials sector consists of 11% of the S&P 500, while materials makes up 3%.
"While these areas of the market can benefit returns over an economic cycle, investors may want to avoid high concentrations of exposure, particularly in the later stages of an economic cycle or if their goals are focused on wealth preservation," Reid says.
Some materials stocks with fast earnings growth include Newmont Goldcorp. (NEM), CF Industries Holdings (CF), and FMC Corp. (FMC) while industrial stocks with good earnings growth include W.W. Grainger (GWW), Nielsen Holdings (NLSN), and Flowserve Corp. (FLS), Denier says.
|For more news you can use to help guide your financial life, visit our Insights page.|