Spot the Next Outbreak of Material Madness

Over the last few weeks we have watched the scrolling ticker tape in amazement as the Materials Select Sector SPDR (XLB) and Vanguard Materials ETF (VAW) have taken off to new highs. So far this year, these sector ETFs returned 7.4% and 8.3% respectively.

The top five stocks in these two ETFs include a who's-who of large-cap diversified chemicals and metals. These highly rated stocks include E.I. du Pont de Nemours (DD), Dow Chemical (DOW), Alcoa (AA), Monsanto (MON) and Phelps Dodge (PD).

Now, there is nothing wrong with investing in this quintet of large-cap materials stocks. Our quantitative model loves the excess cash these companies are generating and their collective recent spurt of top-line growth. They are all rated buy, and they give you exposure to basic materials.

But where are the next stocks in this sector that might drive investors into a mad buying frenzy and generate real excitement?

Looking closer into the materials sector, we came up with three smaller, less recognized names that look to be excellent options to consider. Note that our definition of "smaller" is relative to the sector.

The average market capitalization of these next three companies is $9 billion, compared with $36 billion for the large-cap materials stocks. The other surprise is that being smaller gives companies' management the opportunity to focus on fewer areas and be leading players in their niches.