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What Role Can These ETFs Play in Your Portfolio?

Exchange-traded funds offer investors many perks that come with combining the attributes of a typical mutual fund and your everyday stock.

On this episode of Industry Focus: Consumer Goods, Motley Fool analyst Vincent Shen is joined by Fool.com senior contributor Asit Sharma to take a look at two consumer goods ETFs -- the Consumer Discretionary Select Sector Fund (NYSEMKT: XLY) and the Consumer Staples Select Sector Fund (NYSEMKT: XLP) -- to gain exposure to a more diversified group of consumer and retail names.

And beyond the ETFs themselves, the cast breaks down their individual stock holdings to look for inspiration in the industry.

A full transcript follows the video.

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This podcast was recorded on Nov. 29, 2016.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Tuesday, Nov. 29, so consumer and retail is on tap. I'm your host, Vincent Shen, and joining me via Skype is senior Fool.com contributor Asit Sharma. How are you doing, Asit? Ready to get back into the swing of things?

Asit Sharma: Almost, Vince. I'm ready to get back into the swing of things, but find that I'm behind going into Christmas. So, yeah, yes is the answer.

Shen: For our listeners, today we're diving into a topic in part of the investing world that I have actually not yet covered as host of Industry Focus, and that is with exchange-traded funds, or ETFs. So, we'll be talking a little bit about some consumer and retail-focused ETFs, not only as investment options or vehicles themselves, but how they can serve as a source of inspiration to find other high-quality companies within the industry. Asit, for anyone who is not as familiar with exchange-traded funds, with a 10,000-foot view, can you give us a quick description of what an ETF is?

Sharma: Sure. Exchange-traded funds are very similar to mutual funds. They enable you as an investor to dive into an investment idea. Someone else that is the fund manager will buy and sell stocks are other instruments in a basket, and allow you to purchase into this investment as you would a stock. So, unlike mutual funds, you can buy and sell an ETF in the same day. They are managed instruments, so they do assess a fee each year. We'll get into some of those details as we go along with the ETFs we're going to talk about today. That's one thing you do have to watch when investing in an exchange-traded fund -- how much you paying for the management of that vehicle. But, to sum it up, very similar to stocks, share some characteristics with mutual funds and equities.

Shen: Yep. On the Fool.com website, they have a breakdown of exchange-traded funds, and they ultimately look at it in terms of what it's called -- exchange-traded -- the key thing here, like a fund, but it trades like a stock, it has a ticker symbol, but it is ultimately an investment vehicle where it holds some batch of tens, hundreds, if not thousands of underlying shares. These have actually been around since the 1990s, but I think they've really grown in popularity in the past decade. I did a quick search as a proxy for that, in terms of Google search activity for the terms "ETF" or "exchange-traded fund," and popularity on Google searches peaked in October 2008, and they have remained relatively consistent since then. Otherwise, some big perks behind ETF investing, as you mentioned, Asit, they're easy to trade straight from your standard brokerage account, they're an easy way to diversify your holdings, they can give you exposure to a certain region or a sector, as we'll discuss here. Whereas with a mutual fund there might be some kind of minimum investment, ranging from $500 to $3,000, here, you can buy a single share of an ETF if you want. For the two funds we're looking at, it might be around $50 or $80. Generally, lower expenses than a mutual fund, and some tax advantages that you can learn more about. But, let's dive specifically into the two funds we're going to talk about. Can you explain how, specifically, with the S&P 500, how it's broken down into sectors, and how that can help us if we're looking specifically at consumer and retail companies?

Sharma: Sure. Listeners, this is your piece of trivia for today -- every single stock that's in the S&P 500 is broken down into one of eleven different sectors. We're going to talk about two ETFs, one in the discretionary consumer sector of the S&P 500, and the other in the consumer staples sector of the S&P 500. What Vince and I love about this topic is these two ETFs give you a way of viewing the consumer goods world. It's a very broad universe of stocks, that covers everything from gaming to retail to travel and leisure. If you're looking for a way to further understand this sector, these two ETFs are a great way to dive in and learn, as Vince mentioned, about a sector we personally find extremely exciting.

Shen: The first one, Consumer Discretionary Select Sector. The ticker symbol for this ETF is XLY. It's been around since December of [1998]. Shares trade currently at around $82. You can see how this is quite accessible to beginning investors with a smaller pool of funds. It attracts about 88 constituents in the S&P, and the mean market cap is about $28 billion, if you weight that it's closer to about $100 billion. But this has some really big companies. Top 10 holdings include Amazon, Comcast, Home Depot, Walt Disney. Very big names. What else can you tell us, Asit, about this fund, and how people can approach it?

Sharma: Let's zero in on this word discretionary. I know, as I became more familiar with consumer good stocks, I kept hearing least two words -- "discretionary" and "staples." For a long time, I didn't really clearly understand what the difference between the two is. This ETF tracks those stocks which try to make their earnings on discretionary income. Amazon is a great example. I had a Prime subscription, I dropped it. As soon as I did, I begin to feel sorry, because to watch some of the content I wanted, I would have to have the Amazon Prime video service, to listen to audiobooks, I would have to have a separate subscription to audible.com. But in both cases, that's my discretionary income. Your discretionary income is non-essential income, and it pours into stocks like Amazon, Comcast, McDonald's

Together, this basket of stocks that we talk about tends to do very well when income rises. Just to give you a few facts on this particular ETF, we mentioned at the beginning of the show the expense ratios. This has an expense ratio of 0.14%. If you're just getting into ETFs, that might sound like an odd number. An ETF can have an expense ratio of less than 1%, all the way up to several percent. Generally, if you hear that an ETF has an expense ratio of below 1%, that's pretty good. This one, being close to 0.1%, it's very efficient in terms of managing your money. It's not a small ETF. It has about $10.8 billion in net assets. It also pays a dividend based on the aggregate dividends it collects of about 1.5%. 

Let's talk about valuation. If you wanted to jump in and buy this ETF, you might be curious -- how does it stack up against the market as a whole? One big-picture thing to understand about consumer good stocks in general is, they tend to track the broader market. This ETF has a forward P/E of close to 20. That means the stocks, on average, in this basket, traded at about 20 times forward one-year earnings. It's about the same as the general market, in terms of valuation. One last thing is, this ETF has a beta of 1.0. That means, in terms of volatility, it's right about as volatile as the rest of the market. We equate the volatility of 1.0 with the market. If you're above that number, you're a more volatile instrument, and if you are below it, you are a less volatile instrument.

Shen: Yep. That's a really great rundown of some key stats and attributes of this fund. There's another piece of the information that they share in their fact sheet, which is a breakdown of the industries you're buying into by weight. Media is the biggest, it's about 23% of the holdings. Beyond that, you have internet and direct marketing retail at about 20%, specialty retail about 20%, hotels, restaurants and leisure at about 13%, it goes down from there. But, besides just the specific companies, you can also get a sense of, big picture, we know this is more the consumer discretionary sub-sector, but then the industries within that, what exactly are you getting exposed to through this fund? If you're more interested in media and e-commerce, for example, this might be something that's right up your alley.

Moving on to the second fund we have, the XLP, this is for the consumer staples. It's been around since 1998. This one is a bit smaller in terms of its holdings. It has 39 constituents. The mean market cap is quite a bit larger, and you'll understand that once you hear the companies that make up the top 10 holdings. The mean market cap I have here is $56 billion. The top three holdings [are] Procter & Gamble, Coca-Cola, Philip Morris. Beyond that, Altria, Wal-Mart Stores, CVS Health Corporation. These are very much some of the biggest names out there within our consumer retail world. It makes sense, if its name, in terms of staples being, regardless of what the economic climate might be, they are not nearly as affected, these are still stores and brands that you are purchasing from on a day-to-day basis. That sound about right, Asit?

Sharma: Yeah. What I find fascinating, Vince, about this is that the people who construct the indexes and put stocks in the sectors have determined that cigarettes, soft drinks, as well as household goods, are staples. You can't do without your soft drinks. They didn't put Coca-Cola in the discretionary funds, they put it in the staples fund, and same with Philip Morris. I guess that is true, and it's based on a lot of observation over the decades. I think it's a great point you make, Vince -- these are household items. Unlike the discretionary fund, which has the more exciting stocks -- e-commerce -- these are characteristic of a defensive play in the market. If you believe, as opposed to discretionary ETFs, which will rise when discretionary income rises, when the economy is expanding, if you are pessimistic about the economy, you might want to buy this ETF and play defense a little bit. 

I wanted to point out the total return of the two versus the S&P 500. Looking at that first ETF, the XLY, the consumer discretionary fund, that has done, over the last five years -- so, this is post-Great Recession -- about 16.8% per year on average. That's about 3% above the S&P 500. This is on a total return basis. The XLP, the consumer staples fund, has averaged about 14.5%, right about 1% better in terms of performance than the S&P 500 over the past few years. So, not quite as great performance. But if you envision the economy slowing down, those numbers might flip, and this might be the more popular ETF investment. Again, going back to our theme about how you can use these ETFs to divide the consumer goods world -- this is a very big-picture way to break it up -- are you playing defense or offense? When we talk about the staples side of things, we're playing defense.

Shen: There you go. Another way I wanted to look at these funds and how investors can view them, not just buying into the XLY or the XLP directly, but to look at their holdings and get some ideas for companies in these sectors or subsectors that you might not be as familiar with. That's what I want to dive into now with two companies that we haven't spoken about in a long time on this Consumer Goods series of Industry Focus. The first one is Monster Beverage Corporation (NASDAQ: MNST). They're down about 9% year to date. They are a member of the XLP. I think, recently, the big news for this company has been the partnership they've made with Coca-Cola. They have started to make more and more of a transition to Coca-Cola's distribution system, so they've really been able to expand worldwide. They recently made it into markets like Mexico, Chile, Brazil, South Africa, and also China -- they launched in Beijing, Shanghai, the past couple months. What do you think about Monster Beverage and some of the adjustments they're making as they make this international expansion?

Sharma: The Coca-Cola deal was very beneficial to Monster, as you pointed out, they've really expanded their global footprint. At the same time, Monster is falling victim to forces that the other beverage companies and sectors are being hit by. One of those is soda taxes. That's something that you and I have talked about on this show before, Vince. It seemed like Monster was a fast-growing entity, and this is the first time in the last few quarters where we've seen a bit of investor skepticism that this might hurt Monster as well. Even though it is an energy drink business, it has a lot of sugar in its products. Again, what happens if you're holding consumer discretionary income, and a soda tax hits in your municipalities? We have seen this in Berkeley and some other cities. Then you might be less inclined to buy soft drinks and energy drinks. So, it's sort of a headwind on the stock, which is very germane to the theme we've been talking about today. However, I do like Monster because its particular part of the beverage world, the energy drink business, is growing at about 3.5% compounded annual growth rate every year. Now, that doesn't sound like a huge amount, but if you compare it to a flat or negative growth rate for soda, it has more of an addressable market that it can tap into, and it has every potential to resume its fast growth that we've seen in years past. 

Shen: Absolutely. I think it's important to note, you mentioned taxes and some of the other regulatory pressure that some of the beverage companies and some of the other companies in the space are seeing. But ultimately, even if that results in some greater expenses as they try to fight some of that, overall, this company has very strong financials. They have significant cash flows with an equally strong balance sheet. I think they have something like $600 million in cash and short-term investments, and that's with no debt. They've repurchased about $2 billion of shares just in 2016, that's really helping to juice their EPS (earnings per share) growth. Their profit margins, as a result of their expansion, their partnership with Coca-Cola becoming more efficient, both their gross and net margins have managed to grow quite steadily over the past year or two. This is definitely one where, with that footprint growing, with China, and they're also soon going to be breaking into other major markets within Latin America, Central Asia, the Middle East and Africa, it's a very interesting company to watch, for sure.

For our second company, I wanted to pull this time from the XLY fund. This is one we've never covered, as far as I can recall, on this Consumer Goods series for Industry Focus. That's with O'Reilly Automotive (NASDAQ: ORLY). Typically, on Fool.com, they might be covered under the industrial sector, but obviously still very much a retail-facing side to their business. Basically, they're selling auto parts and other more common consumer supplies, like your motor oil, your anti-freeze. Their business is split about 50% to what they call their do-it-yourself segment, and 40% to their professional segment. They seem to have some really nice tailwinds in the idea that, cars are staying on the road longer than ever, technology has allowed them to be much more reliable, and the average age, I have here from a USA Today report, of cars on the roads in the U.S. is about 11.5 years, which is, I believe, the highest in history. What do you think about O'Reilly Automotive?

Sharma: I like it. I want to read out a few stats. It has 4,700 auto parts stores in 45 states. It's very well spread around the U.S. And there's a good chance our listeners have at least driven past one, if you're not a customer. I like that they're growing their sales at a pretty good clip. This past third quarter, revenue increased 7% on a year-over-year basis. Same-store comparable sales increased 4%. It has pretty decent margin for an automotive retail chain. It has about a 23% net profit margin through the first three quarters of this year. 

This is one of those instances where studying the ETF and learning about the industry helps you understand the company better. If I had just asked you before this podcast which of the two companies we just talked about is the staple and which is the discretionary, you might have said the staple Is O'Reilly Automotive and the discretionary stock is Monster Beverage Corporation. Monster Beverage Corporation is the staple because remember the S&P 500 geniuses who put together the index say that we need that energy drink, and O'Reilly Automotive is the discretionary because when your income rises, you have more in your pocket to maybe do that project yourself, you probably have some leisure time and the inclination to go and buy that part and tinker with your vehicle. As incomes decline, this potentially hurts O'Reilly Automotive. But, they've been a beneficiary of the growth that we've had post-recession. I like it very much. I think that it's a small enough footprint there's quite a bit more for it to expand into. The company has added about 140 stores this year. It definitely can keep growing that base. It's in a good sector. Gas prices are low. The average age of cars is, as you pointed out, getting longer. This company, like Monster, is in a good position for years of sustainable revenue growth. I think it's another buy.

Shen: I was just thinking about something I saw, the company has mentioned that there's been a growing trend in terms of their DIY category, people being more willing to do that work on their car, which has benefited them. Also, they had that dual exposure on the professional side. Sometimes, with the explosion of things like YouTube and online guides and the information you can get online now, it does make things like repairing something smaller on your car much more approachable and accessible. Just a thought that I had. In this case, that technology side will benefit companies and sectors that you don't really expect.

Sharma: That's a wonderful point, Vince. I'll just briefly state that you need two things for the do-it-yourself project. You need time, you often need a little bit of money, that discretionary income, and you need confidence. Technology, from Amazon, from the content providers, but more pertinent, as you're saying, from places like YouTube, makes it simple for a guy like me, who's not very mechanical, to do something small, go to the auto parts store and pick up a part and put it in, which I probably wouldn't do if we didn't have YouTube. That's a very perceptive point. It's one of those intangibles that helps the bottom line of companies like O'Reilly Automotive.

Shen: Thank you very much, Asit. That wraps up our discussion today for these two ETFs, and some companies that we pulled from their holdings. If you have any questions, you can reach out to us or anyone else on the Industry Focus crew via Twitter @MFIndustryFocus. Any other questions can also go to us via email at industryfocus@fool.com. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!

Asit Sharma has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com, Monster Beverage, and Walt Disney. The Motley Fool owns shares of O'Reilly Automotive. The Motley Fool recommends Coca-Cola, CVS Health, and Home Depot. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.