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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.

And Stewardship >= Standard

Finally, we ran a screen for a Morningstar Stewardship Grade for stocks of either Standard or Exemplary grade to ensure that the resulting companies are run by a quality management team. This rating represents our assessment of management’s stewardship of shareholder capital, with particular emphasis on capital-allocation decisions. Analysts consider companies’ investment strategies and valuations, financial leverage, dividend and share-buyback policies, execution, compensation, related party transactions, and accounting practices.

We ran this screen in April using Morningstar Principia. Here are some of the results.

Alcoa AA
We believe Alcoa operates with a narrow economic moat. While its products are largely undifferentiated commodities sold into cyclical end markets with little pricing power, the company operates with considerable scale as the largest producer of alumina and has one of the largest global aluminum operations. Alcoa’s size enables the company to lower its costs by optimizing its energy usage and improving the efficiency of procurement, distribution, and overhead. Alcoa’s upstream operations traditionally generate double-digit operating margins. Alcoa also has significant cost advantages from its vertical integration (mining 85% of its bauxite needs and producing 100% of its alumina needs), as not only does it source a significant share of its raw material needs at cost, but also the mining and refining businesses are attractive assets themselves, generating the highest operating margins and the highest return on assets among Alcoa’s segments. Large barriers to entry in the upstream operations stem from high initial investment and fixed costs, the somewhat low value/weight ratio of aluminum, and the importance of proximity between the refinery and the raw material source.

Cloud Peak Energy CLD
Cloud Peak is the lowest-cost player in the lowest-cost coal mining region in the world: the Powder River Basin. We think that coal prices in the basin will increase significantly from current levels of $10 per ton over the next few years because $10-per-ton coal is a much more cost-effective option than natural gas for most domestic power plants to burn. Also, the basin’s coal prices lie well below the operating costs of marginal operators. We believe above-average coal inventories at power plants are keeping the lid on coal prices, but also believe inventories will be slowly worked down. We think Cloud Peak shares could enjoy significant upside, especially as Powder River Basin coal prices recover to a more normalized level. However, we project the firm’s earnings to decline over the next several quarters before hitting their trough in early 2014 (due to contract pricing), meaning investors may have to be patient.

Intrepid Potash IPI
With mines close to its U.S. customers, Intrepid Potash benefits from lower freight costs and higher realized sales prices compared with companies operating Canadian mines. Intrepid is a small player in the potash market, but that does not preclude it from benefiting from positive industry dynamics, including barriers to entry and oligopolistic pricing behavior. We think the price of potash will drive Intrepid’s future results. We think long-term potash prices will remain above marginal costs of production, supported by the concentrated nature of the industry. However, we’re predicting industry supply will rise faster than demand over the coming years, leading to pressure on prices. Intrepid’s potash costs per ton should start to decline in 2014 with the ramp-up of production at the company’s new solar solution facility.

Steel Dynamics STLD
We believe Steel Dynamics operates with a narrow economic moat. The company is a relative newcomer to the steel industry and, therefore, has some of the newest and most efficient mills in the business. It has a very low operating cost structure and higher productivity than its peers because it produces steel in electric arc furnaces, which are less capital-intensive, consume less energy, and provide greater operational flexibility than traditional blast furnaces. Steel Dynamics has also established an important strategic foothold in raw materials, investing in both iron- and scrap-producing assets, which not only gives the company more control over its input supply and costs, but enables it to exploit the changes in steel and raw-material prices, adjusting its internal raw-material consumption to maximize profitability. The company’s average return on invested capital from 2004 to 2012 was 14.7%.

John Zecy is an associate equity analyst at Morningstar.

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