When basic-materials stocks fall prey to doom-and-gloom scenarios, investors can gain profits that aren’t just cyclical.
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.
We tend to look more favorably at thermal coal producers, especially ones that have the ability to export their production to Asian markets. Even if China rolls over in terms of fixed-asset investment, the assumption would be that their use of electricity would tend to be more stable, is issue gold-price-linked dividends that will change in tandem with gold-price changes. It gives investors income, which gold-backed ETFs do not; and it gives more-direct leverage to gold prices than the whims of the market in terms of gold-mining shares’ depreciation or appreciation. It is a bit risky because, if a company links their dividend to gold prices without some release valves for cost pressures or production disruptions, they could be a position where they promise to pay out a certain dividend level, but it would actually hurt their financial health if they’re suffering from high costs of reduced production. But a dividend is not a contract, it’s more of a promise that gets voted on.
From Morningstar’s perspective, it’s a really good idea because gold-price-linked dividends give companies less available cash at good times, and they give companies a source of cash during tough times when their operations are throwing off less cash.
I mentioned the several reasons that gold companies have lost ground against gold prices; I forgot to mention gold-price expectations. That’s one of the easiest explanations—it’s likely that equity valuations incorporate long-term gold prices nearer to $1,100 an ounce versus the $1,700 an ounce that we’re seeing today.
Joung Park: And mining executives are even more conservative about gold-price assumptions--something like $1,000 or $900 is what they’re using for their reserves accounting.
Collins: But I would argue that, in their minds, mining executives are very bullish.
Guziec: Are the secular trends baked into market prices and our valuations? There’s only so much iron ore, only so much metallurgical coal …
Collins: I think in general we tend to be in agreement with market participants on which industries have the most-favorable demand factors. But sometimes the market, in times of uncertainty, can be more nearsighted. And when you see cyclical concerns topping favorable long-term trends, that’s when you have more investing opportunities.
Guziec: Can we identify any companies in basic materials that have economic moats and aren’t subject to as much cyclicality or as much risk to the underlying valuation?
Collins: We talked about thermal coal earlier, and Cloud Peak CLD is one company we like for the long term. They have low-cost production in the Powder River Basin in Wyoming, and there’s an increasing opportunity for them to transport that to Asian markets. The market just isn’t as favorable on CloudPeak as it should be.
Park: Among the gold miners we like, we like Yamana Gold AUY the best. We like Yamana because it’s somewhat of a turnaround story. It’s not getting as high of a valuation as some of the other similar gold miners; the company did have some operational issues in the past that I think were temporary because they were undergoing major acquisitions, and it takes some time to integrate such transactions. It’s not as undervalued as it had been, but we think it has some room to go.
Freas: I would say ArcelorMittal MT. It’s by far the largest steel company in the world, and its scale, distribution capabilities, and operational flexibility are unmatched. But the main reason I really like it right now comes down to valuation. This is a stock that has just gotten killed in the past couple of months. Obviously it’s a stock that’s going to swing pretty hard with the economic sentiment, but if you look at the company and how it’s operating, there are a number of things that the market is sort of ignoring. For the stock to fall 60% in the past few months is unjustified.