Retail HOLDRS (RTH) is our top pick for consumer discretionary sector ETFs.  RTH is one of 51 ETFs that gets an attractive-or-better rating. We rate the investment merit of the top six consumer discretionary sector ETFs based on our coverage of 471 stocks in this sector.

Per our first-quarter-2011 review of U.S. Equity Sector ETFs, the consumer discretionary sector is one of three sectors that gets our “attractive” rating. Per Figure 2, the consumer discretionary sector allocates 34% of its value to stocks with an attractive-or-better rating. 26% of its values goes to dangerous-or-worse-rated stocks.

Some good stocks in the consumer discretionary sector to buy individually or as part of an ETF are McDonalds (MCD), Ford (F), Nike (NKE) and Target (TGT). Some stocks to avoid, sell or short in the consumer discretionary sector are Disney (DIS), CBS Corp (CBS), NetFlix (NFLX) and Starwood Hotels & Resorts Worldwide (HOT).

Though the consumer discretionary sector offers many stocks with strong investment potential, not all ETFs can be trusted. Investors must assess the merits of each ETF based on its constituents. Per Figure 3, there are several ETFs to avoid in this sector.

Figure 1: Consumer Discretionary Sector – Capital Allocation & Holdings by Risk/Reward Rating

Sources: New Constructs, LLC and company filings

When analyzing the consumer discretionary sector ETFs, we started by identifying those ETFs with acceptable structural integrity as measured by XTF, an ETF research firm. We chose the six ETFs whose XTF rating was above the sector average XTF rating.

Figure 2: Consumer Discretionary ETFs With Acceptable Structural Integrity

Sources: New Constructs, LLC; XTF and company filings

Figure 2 shows clearly that not all consumer discretionary ETFs are made the same. Different ETFs have meaningfully different numbers of holdings and, therefore, different allocations to holdings. Given the differences in holdings and allocations, these ETFs will likely perform quite differently.

After determining the structural integrity, we analyzed the investment merit of each ETF based on how it allocated value to each stock it held. Figure 3 shows how the six consumer discretionary sector ETFs stack up versus each other and the overall sector based on their overall risk/reward ratings and the allocation of their holdings by rating.

Figure 3: Investment Merit Based on Holdings and Allocations

Sources: New Constructs, LLC; XTF and company filings

 

Attractive ETFs:

RTH is the only consumer discretionary ETF to earn an attractive rating and, therefore, is the only consumer discretionary ETF we recommend.

Neutral ETFs:

XLY, VCR, PBS, and XRT allocate the value of their funds in a way that earns them a neutral rating. We recommend investors buy the very Attractive and attractive stocks in this sector before buying any of the consumer discretionary ETFs except RTH. Contact us for the full list of 102 consumer discretionary companies that earn an attractive-or-better rating.

Dangerous ETFs:

We recommend investors avoid or sell short XHB because of its dangerous rating.

Benchmark Comparisons

Sector Benchmark

RTH’s ratings are the same as the overall sector’s ratings, except for price-to-EBV and growth appreciation period (GAP). RTH has a significantly shorter GAP than the overall sector (11 years versus the sector’s 29-year GAP), earning it a neutral rating. However, RTH has a higher price-to-EBV compared to the sector (1.5 versus the sector’s 1.1 Price-to-EBV).

Figure 4: RTH – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

Figure 5: Consumer Discretionary Sector – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

RTH more effectively allocates capital than the overall consumer discretionary sector. Per Figure 3 above, RTH allocates 42% of its value to attractive-or-better-rated stocks while the sector only allocates 36%. RTH also allocates none of its value toward dangerous-or-worse-rated stocks compared to the sector’s dangerous-or-worse weightings of 26%.

For explanation and details behind our risk/reward rating system, see one of our company valuation reports, which are available for free here.

Market Benchmark

RTH outperforms the S&P 500 in valuation ratings. RTH earns an attractive free-cash-flow yield rating compared to the S&P 500’s neutral rating. RTH also has a neutral GAP rating compared to the S&P 500’s dangerous GAP rating.

RTH has similar quality of earnings ratings compared to the S&P 500. RTH’s market-weighted ROIC of 11.8% earns it an attractive rating while the S&P 500’s market-weighted ROIC of 18.3% earns it a very attractive rating.

Figure 6: RTH – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

Figure 7: S&P 500 – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

RTH allocates capital more effectively than the S&P 500. Per Figure 3 above, RTH allocates none of its value to dangerous-or-worse-rated stocks while the S&P 500 allocates 24%. RTH and the S&P 500 similarly allocate capital to attractive-or-better-rated stocks.

Methodology

This report offers recommendations on consumer discretionary sector ETFs and benchmarks for (1) investors considering buying Consumer Discretionary sector ETFs and for (2) comparing individual ETFs to the Consumer Discretionary sector and the S&P 500. Our analysis is based on aggregating results from our models on each of the companies included in every ETF and the overall sector (471 companies) based on data as of April 19th, 2011. We aggregate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to analyze ETFs in the same way they analyze individual stocks.

To make an informed ETF investment, investors must consider:

1)    The structural integrity of the ETF and its ability to fulfill its stated objective. We use XTF, an ETF research firm, to find the top six ETFs with the best structural integrity rating.

2)    The quality of the ETF’s holdings. We determine an ETF’s quality using our stock ratings.

Given the success of our Rating system for individual stocks, we believe its application to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buying decisions. Barron’s regularly features our unique ETF research.

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