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Uncertainty and Value in Basic Materials

Long-term investors who see a Chinese juggernaut down the line would do well to check out these firms.

Haywood Kelly, 08/31/2010

Among the companies most sensitive to global economic trends are those producing the basic materials that satisfy the world's growing needs. Aluminum and steel producers fall into this category, as do paper companies and coal producers. In necessity lies their attraction. For contrarian investors, buying these stocks when they're out of favor can produce fantastic returns. And for long-term investors bullish on global--and particularly Chinese--growth, these are stocks to own. We recently asked members of our basic-materials team-- associate director Elizabeth Collins and analysts Dan Rohr (mining), Bridget Freas (steel and aluminum), and Mike Tian (coal)-- to untangle some of these questions for us.

Q: Commodities firms are notoriously cyclical. Where are we in the cycle?
Dan Rohr: Most basic-materials stocks declined from post-crisis highs in the second quarter as investors grew increasingly skeptical of a v-shaped global economic recovery. Mounting bearishness largely stemmed from the sovereign-debt crisis in Europe and the knock-on effects that a tighter fiscal policy would have on European demand for basic materials ranging from copper to cement to paper. Meanwhile, Chinese government officials have grown increasingly vocal about the need to clamp down on the country's real estate boom, prompting investor worries that one of the biggest demand drivers during the past several quarters would be cut off at the knees before OECD demand had recovered to pre-crisis levels. On the flip side, China's recent statement that it intends to relax the yuan's peg to the dollar could augur well for China's basic-materials demand, because a stronger yuan would mean increased purchasing power for importers in China.

Q: Metals prices are down significantly, are they not?
Rohr: The biggest concern facing metals markets today is that Chinese demand, which has held up better than OECD demand, will slow. Metals prices have fallen quite a bit from their 2010 highs. As of July 8, copper traded at $3.01 per pound, down 17% from its $3.61-per- pound high. Nickel has dropped 30% to $8.76 per pound. And spot iron ore is down 34% to $122 per metric ton from $186 per metric ton.

Q: What about steel?
Bridget Freas: The first half of 2010 was bright for the global steel sector, with steel prices catching up to higher raw-material costs, inventories staying low, and noticeable signs of strengthening demand, particularly in the automotive and appliance sectors. The tide may be turning in the third quarter, however, as the European debt crisis and China's measures to cool its property market are damaging the demand outlook, leading to the announcements of planned or potential steel output cuts for the third quarter by Severstal, ArcelorMittal MT, and Chinese steel mills. The signs of weakness come at a troubling time for steelmakers, which are trying to manage the recent surge in key raw-material costs.

Meanwhile, oversupply concerns are building in China: Baosteel and other major Chinese producers have announced steel price cuts for July. Steel production in China fell in May after hitting new monthly records for the first few months of the year. We believe that the country is opting to rein in output rather than face global criticism by exporting any oversupply. Chinese steel exports reached their post-recession high in May, and we expect to see declines going forward. By contrast, steelmakers outside China, such as ThyssenKrupp TKA, ArcelorMittal, and Posco PKX have actually announced price increases for the third quarter. By keeping the supply/demand equation in balance, these major players are hoping to pass on the soaring input costs to their customers.

Q: And aluminum?
Freas: A similar dynamic is playing out on the aluminum front, with lower output an even stronger possibility in the near term. Aluminum prices have slumped around 20% since the upward surge reversed in April. Many aluminum producers were not able to restart capacity like the steelmakers did in late 2009 and early 2010, because aluminum prices were just barely at the cash cost of production for many of the high-cost smelters that were previously idled. The pullback in aluminum prices is now causing further delays in restarting capacity in the developed world, while rising energy costs in China are likely to force significant smelter closures in the latter half of the year. The price of aluminum is still some 40% below the 2008 peak, and we expect the closure of these high-cost smelters will keep supply in check and prevent further price declines. PAGEBREAK

Q: Let's turn to stocks. Are there reasons to be bullish?
Rohr: Despite recent declines, metals prices remain well above prior-year levels, resulting in rapid cash accumulation at many mining companies. Initially, much of the windfalls were applied toward shoring up liquidity and paying down debt that was accumulated in the 2007-08 boom. Barring a precipitous drop in metals prices, most miners will continue to build cash, in some cases potentially in excess of total outstanding debt. What, then, to do with the cash? With balance sheets in relatively strong shape, shareholders should expect better dividend payouts.

Q: Any companies in particular?
Rohr: We think investors in Freeport-McMoRan FCX and Xstrata XTA could see a dividend hike in the coming quarters. Another potential lift to basic-materials stocks is that many companies may be tempted to return to the deal market. Thus far in 2010, deal-making has paled in comparison with what we saw in 2007 and 2008, likely a function of lingering doubts about the strength of the recovery and concerns about mounting government efforts to claim a larger share of the rents produced by mining assets. Government actions have run the gamut, from Australia's much-discussed Resource Super Profits Tax--which would deliver a blow to the bottom line of miners with major Australian assets such as BHP Billiton BHP, Rio Tinto RTP, and Xstrata--to the Democratic Republic of the Congo's efforts to expropriate copper mines from midsized Canadian miner First Quantum FM.

Q: Are valuations of basic-materials stocks attractive?
Elizabeth Collins: The stock price retrenchment we saw in the second quarter has made many basic-materials stocks more palatable from a valuation perspective. We currently have about five stocks with 5-star Morningstar Ratings--meaning that we think they are significantly undervalued--and another 17 with 4-star ratings.

Q: Given the commodity nature of the industries you follow, wide-moat companies are few. But you do cover some. Are any of them attractive?
Collins: Vulcan Materials VMC is a leading provider of aggregates in the United States and enjoys a wide economic moat. Vulcan's collection of quarry assets benefits from high barriers to entry and forms the basis of the company's economic moat. The firm's shares have taken a beating, but we continue to believe that Vulcan's network of attractive assets will allow the company to sustain its wide moat and benefit from positive secular trends in the long run.

Q: Monsanto MON is another wide-moat company, and a controversial name these days. It currently carries a 5-star Morningstar Rating, and the stock has taken a beating. Why do you still like it?
Collins: Monsanto's shares have suffered this year: The Roundup business is resetting to a much lower level of profitability because the tight supply-and-demand balance that sent prices soaring in 2008 has abated and the industry is now struggling under the burden of an inventory overhang and chronic overcapacity. In our view, the current share price now seriously understates the growth and profit potential of the company's market-leading seed and genomics segment.

Q: Two other big firms with moats are BHP Billiton and Rio Tinto. Why do you like those companies?
Collins: Diversification. Geographic and product diversification give both firms more-stable cash flows and lower operating risk than most of their mining peers. They're not dependent on a single commodity or a single region for their profits. And they both have the financial wherewithal to weather the boom-and-bust cycles of the inherently volatile commodity markets. And both stocks are cheap, in our opinion, both trading at discounts to our fair value estimate. BHP also yields more than 3%.

Q: Are you recommending any coal producers?
Mike Tian: We'd highlight Cloud Peak CLD. It's a pure-play Powder River Basin coal miner that ranks among the lowest-cost thermal coal producers in the United States. We expect that this cost-curve advantage will damp some of the ill effects of volatile coal prices. However, a lengthy period of very low prices for PRB coal would still place considerable stress on Cloud Peak's financial health. Historically, Cloud Peak had been one of the less-disciplined producers. For example, it barely reduced production in 2009, even though demand plummeted. We suspect that a poor alignment of management incentives discouraged such discipline. Now, as a public company out from under the control of Rio Tinto, compensation will be much more closely linked to Cloud Peak's performance, not Rio Tinto's. If we are right, then increased discipline should lead to higher prices and margins for all players in the basin.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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