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Let’s Get Back to Basics

Basic materials companies are among the cheapest stocks in our coverage universe.

John Zecy, 06/17/2013

This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

In recent analysis of the price/fair value ratios of Morningstar’s stock coverage universe, we observed that basic materials companies offer some of the steepest discounts to our fair value estimates. As such, we ran a detailed stock screen to find attractively priced basic materials names with durable competitive advantages that could boost an investor’s portfolio returns.

Sector = Basic Materials
And ( Economic Moat = Narrow
Or Economic Moat = Wide )

Our analysts assign a Morningstar Economic Moat to firms that have been able to generate returns in excess of their cost of capital for a decade or more thanks to their sustainable competitive advantages. Moats are typically earned through intangible assets, cost advantages, switching costs, network effects, and efficient scale. In the case of basic materials companies, a sustainable low-cost advantage is the main potential source of an economic moat as firms produce undifferentiated commodities that are in many cases widely fungible. Specifically within resource extraction, favorable geological characteristics are the most important determinants of costs. When considering a company’s future cost position, we incorporate all relevant outlays including: lease and permit costs, all payments to service and equipment providers, development expenditures, production expenses, and royalties.

And PCF <= 12

While a firm may carry sustainable competitive advantages, we want to ensure that we are paying a reasonable valuation. Consequently, we set the cutoff at companies trading at less than 12 times their current price/cash flow.

And Morningstar Rating >= 4

To expand on our valuation screen, we used the Morningstar Rating for stocks and searched for companies with at least a 4-star rating. A number of components drive this score including our estimate of the stock’s intrinsic value based on a discounted cash-flow model, the margin of safety bands we apply to our fair value estimate, and the current stock price relative to our fair value estimate.

John Zecy is an associate equity analyst at Morningstar.

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