Basic Materials: U.S. Construction Activity Provides Shelter From the Storm

• The basic materials sector is trading below our aggregate fair value estimate at a price/fair value of 0.95 on an equal-weighted basis.
• As a result of the deceleration of fixed-asset investment growth in China, our sector outlook points to limited price appreciation for most commodities through the end of the decade.
• Investors can look to exposure to U.S. construction spending for more attractive growth prospects.
• The coatings, lumber, aggregates, cement, and steel industries are likely to be relative winners given our expectation for improving U.S. construction.

Fixed-asset investment growth in China has served as the key growth engine across the broader basic materials space for roughly the last 15 years. With this growth engine sputtering out, pockets of growth in the basic materials sector have become scarce. However, our outlook for residential and nonresidential construction in the U.S. points to an attractive long-term growth story.

The housing market should receive a healthy boost from favorable demographic trends in addition to the easing of macroeconomic headwinds that have delayed a more robust recovery. We forecast an average 1.6 million housing starts annually through 2024, above consensus expectations for 1.4 million to 1.5 million over the next several years. Along these lines, we believe that the U.S. is entering the best decade for new residential construction since the 1970s.

In the nonresidential construction space, we argue that spending will decline modestly as a percentage of total U.S. GDP. Even so, we forecast that construction spending will grow at a 4% annual rate (nominal) over the next decade, an improvement from 3% over the trailing 10-year period. Recent data highlights the fact that an upward inflection is already under way. The trailing three-month average for nonresidential construction spending growth increased at a double-digit rate in each of the last four months, with July spending accelerating to 19.1%.

To capitalize on our outlook for improving residential construction, timber and coatings companies offer the most direct exposure. Investors should look to aggregates, cement, and steel for exposure to rising nonresidential construction spending. Indeed, a handful of companies under our coverage within these industries are trading at a discount to our fair value estimates.

Regardless, given that weak commodity demand growth is likely to keep rolling in from China, most commodity prices offer limited upside potential through the end of the decade, in real terms. In a low-commodity-price environment, we reiterate our view that it is critical to invest in low-cost players in any given industry. Although low prices typically squeeze margins across the entire cost curve, low-cost players are often able to take market share amid challenging operating environments, allowing them to emerge with improved competitive positioning when market conditions stabilize and recover.

Yamana Gold

AUY

Yamana Gold is a Canadian gold miner that operates a portfolio of mines in Brazil, Chile, Argentina, Mexico, and Canada. Yamana boasts some of the lowest production costs across our coverage of gold miners, with 2015 all-in sustaining costs expected to be roughly $825 per ounce. Shares are trading at a significant discount to our fair value estimate because of the impact of weak gold prices and operational concerns. Gold currently trades at roughly $1,100 per ounce, lower than our long-term forecast of $1,283 per ounce by 2018. Lower Yamana share prices reflect the impact of operational concerns, as recently opened mines in Brazil have failed to deliver as expected. However, shares now undervalue the benefits of Yamana's low-cost core portfolio, which accounts for the majority of production.

Cloud Peak Energy

CLD

Cloud Peak Energy mines thermal coal out of the Powder River Basin at attractive production costs. With natural gas prices lingering between $2.50 and $3.00 per thousand cubic feet, coal's cost competitiveness remains weak. However, as natural gas prices rise toward our forecast of $4 per thousand cubic feet, the value proposition provided by PRB coal will be restored, driving materially improved results for Cloud Peak. We also note that the company's share prices have traded sharply lower since early 2014, in line with its significantly more leveraged peers

Barrick Gold

ABX

Barrick Gold is the largest gold producer in the world, anchored by a portfolio of five large mines that constitute roughly 60% of companywide production at very low costs. We expect Barrick's 2015 all-in sustaining costs to be roughly $825 per ounce. Share prices have declined since mid-2014 because of the impact of weak gold prices and questionable capital allocation decisions. Gold currently trades at roughly $1,100 per ounce, lower than our long-term forecast of $1,283 per ounce by 2018. Historically, Barrick's ill-advised capital allocation strategies destroyed value for shareholders. However, under new management, Barrick has focused on maximizing cash flow rather than ounces, paving the way for an improved cost profile and debt reduction. We like Barrick's competitive positioning, and shares are now trading at a material discount to our fair value estimate.

More Quarter-End Insights

• Stock Market Outlook: Minor Correction Not Enough to Make Stocks Cheap
• Economic Outlook: As World Growth Falters, the U.S. Consumer Rolls Along
• Credit Markets: Plummeting Commodity Prices Take Their Toll
• Consumer Cyclical: Near-Term Concerns Over China Create Buying Opportunities
• Consumer Defensive: Upside in Staples Companies With Long-Term Cost-Cutting Opportunities
• Energy: No Rapid Rebound for Oil Prices
• Financial Services: Re-Analyzing Banking Systems and Bank Moats
• Health Care: Recent Pullback Opens Door to More Compelling Valuations
• Industrials: High-Quality Industrials Are on Sale
• Real Estate: For the Strong Stomached, Commercial Real Estate Looking More Attractive
• Tech and Telecom: Still Watching Foreign Exchange Headwinds and the Cloud
• Utilities: Low Rates Keep the Sector's Lovefest Raging