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Our Outlook for Basic Materials Stocks

The near term will surely be bumpy, but valuations look prettier today than they have in years.

Morningstar Analysts, 09/28/2011

--Excessive heat in the Midwest has damaged yield potential for corn. As a result, production will be lower than expected and prices are likely to remain elevated.

--The tremors coming out of Europe and the slowing U.S. economy have certainly played their part in pushing down coal valuations, but the real battle will be fought in China.

--The trends in steel fundamentals this year are eerily similar to one year ago, but with one key difference--they're much better this time around.

In our last quarterly outlook, we wrote that we were looking forward to more buying opportunities in basic materials, as we expected profit warnings and earnings disappointments on a host of issues. We have been surprised with how quickly and severely equity markets have dimmed their view of basic materials companies. In some cases we have trimmed our fair value estimates, but in many others we've kept our long-term forecasts intact. As a result, our coverage universe looks much more attractively valued today than it did three months ago. In late June, our average price/fair value estimate ratio was 0.92, and only 1% of our basic materials companies sported a Morningstar Rating for stocks of 5 stars. Now, our average price/fair value estimate ratio is 0.78, and 15% of our companies are in 5-star territory.

Given macroeconomic uncertainty, the ride is likely to be bumpy for basic materials investors. However, we attempt to value our companies based on long-term earnings expectations reflecting normalized prices, demand, and costs. As such, most of our valuations didn't keep pace with the equity market rally that led into the beginning of 2011. But now that the market's expectations have weakened, we find ourselves with a much more attractively valued basic materials universe than we've seen in several years.

Industry-Level Insights
Agricultural markets remained strong in the second quarter of 2011. Historically tight supplies have kept crop prices elevated, lending demand and pricing support to crop inputs, especially fertilizers. Potash Corporation of Saskatchewan POT, Mosaic MOS, Agrium AGU, and CF Industries CF all posted stellar results in the most recent quarter, as farmers used more fertilizer to boost yields and accepted higher prices upon the backdrop of excellent farmer economics. We think these dynamics will persist over the near term, as both fertilizer and crop supplies are expected to remain tight. Canpotex, the marketing arm of Canadian potash producers, recently announced a long-awaited deal with India for potash shipments in the fourth quarter of 2011 and the first quarter of 2012, with pricing $60 per metric ton higher for the later shipments; this is a sign that supplies are expected to remain tight.

On the crop side, the most recent estimates from the U.S. Department of Agriculture show that excessive heat in the Midwest has damaged yield potential for corn. As a result, production will be lower than expected, and prices are likely to remain elevated. With this year's corn crop not set up to alleviate supply pressure, we think 2012 could be a record year for planted acreage in the United States. Our thesis that it would take multiple growing seasons to return stocks/use ratios to more normal levels seems to be playing out. For seed producers such as Monsanto MON and E.I. du Pont de Nemours DD, continued high crop prices should mean solid volume and less resistance to planned pricing increases. In the coming quarter, we will be closely watching harvest results for final production numbers, yield from competing seed brands, and share fluctuations in the highly competitive corn and soybean seed markets.

Building Materials
A crisis in funding for U.S. infrastructure has been averted--for now, at least. The most recent extension of the federal highway bill was set to expire Sept. 30. By coincidence, the government's authority to collect gasoline and diesel taxes was also set to expire. Typically, "clean" temporary extensions are routine while the two political parties hammer out their differences for longer-term plans. However, the recent shutdown of the Federal Aviation Administration after a short-term extension failed to pass illustrates that the situation in Washington, D.C., is acrimonious. Most players (President Obama, Rep. John Mica (R-Fla.), and Sen. Barbara Boxer (D-Calif.)) lent their support to a temporary extension.

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