Investors Should Buy Alcoa — Through XLB

by Will Ashworth | January 12, 2012 8:18 am

Investors Should Buy Alcoa — Through XLB

U.K. behavioral investor James Montier writes in his book Value Investing: Tools and Techniques for Intelligent Investment that 96% of non-market risk is eliminated by holding 32 stocks. Investors interested in preserving capital might think twice about investing in a single stock, instead choosing to acquire a basket of stocks in the same sector.

For instance, let’s say you’re interested in Alcoa (NYSE:AA[1]), the aluminum manufacturer. Its average daily volume is the highest of any S&P 500 stock in the basic materials sector. Investors tend to follow it very closely, with its quarterly earnings report[2] marking the “official” start of each season.

However, unless you are Warren Buffett and can afford to make wrong calls occasionally, you’re probably better off buying the most liquid exchange-traded fund available. When it comes to basic materials, the ETF with the highest average daily volume is the Materials Select Sector SPDR (NYSE:XLB[3]) at 12.2 million shares per day. It’s as liquid as they come. Read on, and I’ll explain why XLB — or an ETF like it — might be the better call.

Remember Montier’s words. Owning a 32-stock portfolio eliminates almost all potential company risk. Well, XLB has a current market value of $1.86 billion and trades at a forward P/E ratio of 11.2 compared with 11.9 for Alcoa itself. Thus you’re getting 30 stocks — including Alcoa (2.5% portfolio weight) — for a similar, if not cheaper, valuation.

Not to mention you’ve almost entirely reduced the risk of owning Alcoa exclusively. Over the past 10 years, the XLB has averaged an annual total return of 7.7% compared to an 8.8% annual loss for Alcoa. Value investors might find the allure of Alcoa too tempting to pass up, but the average investor will do better managing risk. If someone came up to you on the street guaranteeing XLB’s kind of return over the next decade, you’d be all over it. I’m not saying it will happen, but the ETF has outperformed Alcoa in eight out of the past 11 years. I’ll take those odds any day.

The XLB’s top 10 holdings represent 65.9% of the portfolio. Its top five — DuPont (NYSE:DD[4]), Monsanto (NYSE:MON[5]), Freeport-McMoRan (NYSE:FCX[6]), Praxair (NYSE:PX[7]) and Newmont Mining (NYSE:NEM[8]) — make up 44.6% of the portfolio. Over the past 10 years, these top five stocks have averaged an annual return of 10.8% — 768 basis points higher than the S&P 500. This won’t happen in every period, but it should at least make you think. Also, in addition to diversifying away company risk, by investing in XLB you’re also eliminating some, but not all, industry risk — for instance, the sinking aluminum prices that have been cramping Alcoa.

For the record, I’m not the only one thinking this way. In the past week ending Jan. 11, the XLB has seen a $143.6 million inflow. That’s an 8.3% increase week-over-week. Not only does it make long-term sense, it also appears to have some short-term appeal as well.

Not everyone is interested in or cares about liquidity. For those people, there are other basic material ETFs that might spark some interest.

If you’re into leverage, there’s the ProShares Ultra Basic Materials Fund (NYSE:UYM[9]) that seeks daily investment results twice the daily performance of the Dow Jones U.S. Basic Materials Index. It has 69 holdings, which is a little too much diversification for my taste — not to mention its management expense ratio is 0.95%, 75 basis points higher than the XLB.

If you’re more an iShares type of investor, it offers the Dow Jones US Basic Materials Sector Index Fund (NYSE:IYM[10]), a 70-stock portfolio based on the same index. Its MER is 0.47%, which is far more reasonable and doesn’t provide leverage. In this ETF, Alcoa represents just 2.11% — and again, that’s among 70 stocks. If your heart’s set on Alcoa, this probably isn’t the best choice.

In any of these cases, because ETFs are traded like stocks, it’s a little more difficult to invest on a monthly basis. For this reason, you might consider purchases whenever the fund has experienced a significant downturn. You’ll save on trading costs and likely increase your performance over the long term.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned stocks.

Endnotes:
  1. AA: http://studio-5.financialcontent.com/investplace/quote?Symbol=AA
  2. quarterly earnings report: http://investorplace.com/2012/01/alcoa-earnings-aa-stock-revenue/
  3. XLB: http://studio-5.financialcontent.com/investplace/quote?Symbol=XLB
  4. DD: http://studio-5.financialcontent.com/investplace/quote?Symbol=DD
  5. MON: http://studio-5.financialcontent.com/investplace/quote?Symbol=MON
  6. FCX: http://studio-5.financialcontent.com/investplace/quote?Symbol=FCX
  7. PX: http://studio-5.financialcontent.com/investplace/quote?Symbol=PX
  8. NEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=NEM
  9. UYM: http://studio-5.financialcontent.com/investplace/quote?Symbol=UYM
  10. IYM: http://studio-5.financialcontent.com/investplace/quote?Symbol=IYM

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