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Be Alert for Basic-Materials Bargains

When basic-materials stocks fall prey to doom-and-gloom scenarios, investors can gain profits that aren’t just cyclical.

Philip Guziec, 11/30/2011

The basic-materials sector covers a lot of areas, and it’s also highly cyclical. So, I sat down with some of our basic-materials stock analysts recently to discuss where we are right now with the sector and what investors should be looking for if they’re shopping for some basic-materials exposure.

Philip Guziec: Basic materials is tough to get your head around from an investing perspective. How do we think about investing in basic materials? When do you want to look at basic materials as an investment opportunity?

Elizabeth Collins: You want to start thinking about investing in basic-materials stocks when the market is pricing in conditions that are really bad. These opportunities may be few and far between, but we’ve seen it at least once recently, and we’re maybe about to see another time like that in the near future. An example would be the chance to buy Potash Corp. POT for a price that implies that people will not be using much potash fertilizer ever again. Or an opportunity to buy Freeport McMoRan FCX when the market is pricing in a copper price below $2 a pound from now until forever. We’re not seeing those valuations yet, for those high-quality names, but there are some increasing opportunities in the basic-materials sector now. So, it’s time to start looking at these companies again.

Guziec: It sounds like basic-materials/ commodity investing is analyzing the companies, both with respect to cyclicality and with respect to the secular trend for that product. Where are we, in terms of global economic cycles across the major materials groups?

Collins: In agriculture, we’re actually still very healthy. The industry recovered nicely from a very severe downturn in 2009, and because of weather disruptions and still-strong demand, this is an industry that hasn’t yet started to suffer to the same extent as other industries from macroeconomic concerns in 2011.

Building materials is an industry that, in developed economies, has never recovered from the downturn that began in 2006. It started to suffer with the bursting of the housing bubble in the United States, Spain, and other European countries, and what followed was a downturn in commercial construction activity and, very lately, weak government budgets in Europe and the United States. The outlook for infrastructure spending is more uncertain now.

The chemicals industry is one that broadly follows the economic cycle; it’s not different in the way that agriculture or building materials might be. So, if you’re looking for a shortcut with chemicals, you can say that it’s very much related to GDP growth.

Coal has a pair of different trends--you have thermal coal for power generation and metallurgical coal for steelmaking. Prior to very recently, everyone was very excited about metallurgical coal; firms were investing in metallurgical coal capacity, and investors were buying up companies that produced metallurgical coal because of China’s voracious appetite for steel and steelmaking ingredients. We were skeptical of that trend because metallurgical coal is so sensitive, in this case, to China’s fixed-asset investment. Our theses tended to play out this year, with the producers that leveraged up to purchase metallurgical coal production now being hurt severely.

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