Basic Materials Stocks Look Pricey

The Morningstar US Basic Materials Index underperformed the broader market during the second quarter of 2021 by roughly 335 basis points. Trailing one-year, the materials sector has massively outperformed by nearly 1,100 basis points, just shy of the 1,800 basis points of outperformance a quarter ago. As a result of the rally from the depths of the pandemic, no U.S. basic materials stocks we cover now trade in 5-star territory.

Global materials index vs. global equity index. - source: Morningstar

All materials stocks trade near or above their fair value estimates. - source: Morningstar

The largest source of lithium demand comes from electric vehicles. We expect EV sales will continue to rise globally in 2021, boosting lithium demand. Combined with reduced supply last year as a result of COVID-19-related slowdowns, lithium prices have risen since the beginning of the year and are now slightly above our long-term price forecast of $12,000 per metric ton. Because of continued demand growth, we expect prices to remain elevated over the next several years, which should benefit low-cost producers.

Lithium prices have risen since the beginning of the year. - source: Morningstar

Demand continued to recover for chemicals producers following COVID-19-driven closures. We expect a continued sequential volume recovery through 2021. Within specialty chemicals, we see long-term growth for companies in electric vehicles. EVs require more electronic materials and typically use more polymers to make the vehicles lighter, which allows specialty chemicals producers to generate more revenue per vehicle. As EVs reach cost and functional parity with internal combustion engines, we see EV adoption growing from around 3% in 2020 to over 20% in 2030.

Deicing salt prices fell for the 2020-21 winter following a mild 2019-20 winter. Deicing salt demand volume is driven by winter weather. As such, prices tend to fall following a milder winter as producers carry excess inventory, leading to oversupply. While weather is volatile each year, it tends to revert to the mean over a longer period. The 2020-21 winter had average snowfall. Combined with reduced supply from a mine closure, we expect prices to rise in the 2021-22 season.

Snowfall volatility has increased over time. - source: Morningstar

Top Picks

Sociedad Quimica Y Minera De Chile SA SQM Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $58 Fair Value Uncertainty: High

Narrow-moat SQM is one of the largest lithium producers globally. The stock trades at nearly a 20% discount to our $58 per share fair value estimate. As one of the lowest-cost lithium producers globally, SQM can maintain profitability even as lithium prices fall. Over the long term, we contend that lithium prices will remain at or above $12,000 per metric ton to encourage lower-quality supply to meet demand from the growing adoption of electric vehicles. We think the market is pricing in reduced long-term profits from potential changes to the Chilean Constitution, but we think the company is less likely to be materially affected. We view current share prices as an attractive entry point for a quality lithium producer.

DuPont de Nemours DD Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $92 Fair Value Uncertainty: Medium

Our top pick to play specialty chemicals demand growth is narrow-moat DuPont. The stock trades at a nearly 17% discount to our $92 per share fair value estimate. DuPont is well positioned to benefit from increased demand in many of its end markets. The company should see growing profits from greater adoption of electric vehicles as it generates roughly 50% more revenue per vehicle than from internal combustion vehicles. The firm should also see increased demand from a growing number of 5G-enabled devices and a recovery in U.S. housing starts. We view the current share price as an attractive entry point for the quality specialty chemicals producer.

Compass Minerals International CMP Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $78 Fair Value Uncertainty: High

Wide-moat Compass Minerals is our top pick to play a rebound in deicing salt prices, trading at roughly a 25% discount to our $78 per share fair value estimate. Compass’ cost-advantaged salt production stems from its Goderich mine, which also benefits from being on Lake Huron. This allows Compass to both produce and transport at a lower cost than competitors. Although Compass has seen higher costs in recent years owing to temporary operational issues, unit costs have since fallen, and we expect further declines over the next couple of years.