XME: Simple metals and mining index ETF, cheap valuation, effective inflation hedge

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Soaring commodity prices boosted revenues and profits for most mining companies, leading to significant capital gains and outperformance for their shareholders. There are several ways to take advantage of these trends. Investing in SPDR S&P Metals and Mining ETF (NYSEARCA:XME), a US mining and metals index ETF, is a particularly simple and effective way to do this. XME offers investors broad exposure to the US metals and mining industry, has seen strong earnings growth in recent months, is at a cheap valuation and has significantly outperformed year-to-date. The fund is a buy, and particularly suitable for equity investors looking to profit from soaring inflation.

XME only earns 0.50%, and is therefore a largely inefficient income vehicle. Investors looking for income and metals & mining ETFs might instead consider the iShares MSCI Global Metals & Mining Producers ETF (PICK). PICK is a similar fund, focused on overall metals and mining companies, and returns 5.4%, a reasonably good amount.

XME – Basics

  • Investment Manager: State Street
  • Underlying index: S&P Metals & Mining Select Industry Index
  • Expense ratio: 0.35%
  • Dividend yield: 0.53%
  • Total returns 10-year CAGR: 4.58%

XME – Quick Overview

XME is an American metals and mining index ETF. It tracks the S&P Metals & Mining Select Industry Index, an index of those same securities. It is a relatively simple index, comprising all relevant US metals and mining stocks, according to the Global Industry Classification Standard (“GICS”). It is an equally weighted index, to ensure a minimum of diversification (it is a relatively small and concentrated industry). The sector weightings and largest holdings are as follows.

XME Sectors

XME Corporate Website

XME Holdings

XME Corporate Website

Apart from the above, nothing else stands out from the fund’s underlying index. It is a simple index that accurately tracks the US metals and mining industry. This has several significant advantages and disadvantages. Let’s take a look at these, starting with the benefits.

XME – Advantages

Moderately effective inflation hedge

XME’s holdings primarily produce single commodity products. When inflation is high and commodity prices rise, these companies’ revenues, earnings, and cash flow tend to rise, leading to higher stock prices, strong total returns, and outperformance. This makes the fund a reasonably effective hedge against inflation, an important benefit for shareholders.

Let’s run through a quick example of the above, using Nucor (NUE), one of the fund’s largest holdings and representative of the fund. NUE is a steel manufacturer, whose revenues, profits and cash flow are highly dependent on steel prices. When demand is strong, inflation high, and raw material prices rise, steel prices tend to rise to unacceptably high levels, which boosts company finances. Steel prices have roughly tripled since their pandemic low, driving earnings up fivefold, while stock prices have doubled. The NUE has significantly outperformed in recent months of soaring inflation, as expected.

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Data by YCharts

Generally speaking, XME’s holdings are all quite similar to NUE and therefore tend to outperform when commodity prices are high and inflation is high, a plus for the fund and its shareholders.

On a more negative note, the effectiveness of the fund as an inflation hedge is indirect and depends on sentiment and market forces. One could imagine a situation in which inflation rises, the fund’s holdings see earnings rise, but stock prices plummet as sentiment turns bearish. For example, the fund suffered moderate losses in January 2022, in line with broader equity indices, even as commodity prices rose. Sentiment was quite bearish at the time, investors were selling their stocks indiscriminately, and so XME and its underlying holdings saw share prices fall. Markets reassessed the situation in February, so these are short-lived losses. In March, XME outperformed the S&P 500, in line with fundamentals. There is, however, no guarantee that the markets will act quickly next time around. Markets can stay irrational longer than you can stay solvent, as the saying goes.

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Data by YCharts

Due to the above, XME is only a moderately effective hedge against inflation. This should outperform when inflation is high, and that has was the case before, but results depend on unstable market sentiment and are not guaranteed.

High increase

Rising inflation and commodity prices boosted revenue, earnings and cash flow for most of XME’s underlying holdings. Most have seen incredibly strong triple-digit growth over the past two years, thanks in part to favorable comparisons to 2020, when the pandemic was in full swing. Growth is currently averaging/expected at 29% per year, a high figure.

XME Growth

XME Corporate Website

XME’s growth is a bit higher than the stock market average of 20%.

S&P 500 Growth

Vanguard company website

XME’s strong growth is a significant benefit to the fund and its shareholders and could easily lead to above-market returns in the months ahead.

Cheap assessment

Growth funds and stocks tend to trade at premium valuations, but this is not the case for XME. The fund is currently trading with a PE ratio of 5.7x, which is extremely low and slightly below the equity average of 20.3x. The fund’s PB ratio of 2.1x is also well below the equity average of 3.9x.

XME Rating

XME Corporate Website

S&P 500 Valuation

Vanguard company website

XME’s cheap valuation could result in meaningful, above-market returns if market sentiment improves and valuations normalize. Which brings me to my next point.

Potential and actual outperformance

XME’s strong growth and cheap valuation is an incredibly powerful combination. Cheap valuations mean that potential capital gains and returns are quite high, and high growth rates act as a catalyst for these. Investor sentiment regarding value, the old economy and commodities has been quite strong all year, so the conditions are in place for significant outperformance. This has been the case since the beginning of the year, as expected.

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Data by YCharts

It is important to note that the conditions that have led to XME’s strong performance in recent months remain unchanged. Inflation remains high, revenues and profits are soaring and valuations remain cheap. As long as conditions remain as they are, further outperformance is likely, at least in my view.

XME – Risks and Negatives

The potential returns of XME are quite high, but so are the risks of the fund. Commodity producers tend to fare quite poorly when demand weakens, as they don’t have the pricing power/moat to support prices or sales. Expect significant losses and underperformance during downturns and recessions, as was the case in 1Q2020 at the start of the coronavirus pandemic.

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Data by YCharts

The fund also underperformed during the last financial crisis, as expected.

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Data by YCharts

XME outperforms when commodity prices rise, underperforms when commodity prices fall. Commodity prices are cyclical and go through long periods of decline, so long periods of underperformance are to be expected. For example, commodity prices were quite low during the 2010s, following the financial crisis and the resulting weak economic recovery. XME posted moderate losses during this period, while the broader stock indices saw significant gains.

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Data by YCharts

XME is a relatively risky investment and will almost certainly underperform significantly during future downturns, recessions and crunches in commodity prices. Although these scenarios do not seem very likely under current market conditions, conditions are continually changing and significant underperformance in future periods is extremely likely. Although all funds and equity investments are risky, XME is significantly riskier than average. Periods of decades of significant underperformance like above are rather rare and incredibly negative for shareholders. As such, the fund is only a suitable investment for more aggressive investors.

Conclusion – Buy

XME’s effectiveness as an inflation hedge, strong growth, cheap valuation and recent/potential outperformance make the fund a buy.

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