Basic Materials: China-Dependent Producers Largely Overvalued

• We continue to regard the basic materials sector as overvalued. We expect this year's credit-fueled increase in Chinese fixed-asset investment to prove unsustainable, ultimately giving way to weaker demand and prices for China-leveraged commodity producers. Our coverage universe traded at a market-capitalization-weighted price/fair value of 1.28 as of Aug. 31.
• Our bearish China outlook informs an especially negative outlook on industrial commodities, with below-consensus price forecasts for aluminum, copper, iron ore, and steel. Although we're relatively more positive on gold, we expect eventual rate hikes to trigger a reversal in recently strong investor inflows. Whereas we had viewed gold miners as attractive less than a year ago, the space looks largely overvalued today.
• Among the major macroeconomic drivers for materials stocks, we're most positive on U.S. housing. Household formation among millennials, while delayed, is likely to drive meaningfully stronger new construction through the end of the decade. We prefer lumber producers for housing exposure.

Heading into the fourth quarter, we regard much of the basic materials sector as overvalued. Materials stocks have generally performed well in 2016, with highly leveraged mining and steel industries companies among the standouts. But with much of the strong performance depending on credit-fueled Chinese fixed-asset investment spending, we doubt its sustainability.

Chinese credit growth has continued to outstrip GDP growth this year as incremental returns on investment further diminished and an increasing share of new credit went to cover losses at heavily indebted state-owned enterprises. According to figures recently tabulated by the Bank for International Settlements, China's debt/GDP ratio has swollen to 30 percentage points above trend, a "gap" well in excess of the 10 percentage points the international body regards as a "reliable early warning indicator of banking crises or severe distress." While state control of the banking sector and limited reliance on foreign credit diminish the likelihood of a financial crisis, persistent overinvestment and capital misallocation are likely to weigh heavily on China's growth prospects in the years to come.

Our coverage universe traded at a market-capitalization-weighted price/fair value of 1.28 as of Aug. 31. Steel companies and industrial metal miners look especially expensive. Among the pockets of opportunity are companies leveraged to U.S. housing, where we expect construction activity to improve materially in the years to come.

Conditions in the iron ore market are emblematic of the recent rally's unsustainable quality. Buoyed by accelerating Chinese fixed-asset investment, iron ore prices of $55 per metric ton (as of Sept. 19) sit roughly 50% above their December bottom of $37. We continue to expect iron ore prices to decline to $30 per metric ton (in real terms) by 2025 as Chinese steel demand, the main driver of iron ore demand globally, declines and new low-cost supply enters the market.

Falling Chinese steel demand is likely to exacerbate overcapacity problems in China, which bodes ill for U.S. steelmakers. Although shares of major U.S. steel producers have fallen in the past couple of months, they still trade far higher than they did to begin the year, aided by higher steel prices, the perception of improved supply discipline in China, and protectionist trade cases. We doubt any of these three factors will prove strong enough to justify current elevated share prices. Instead, we see considerable downside through the end of the year. Additionally, our near-term demand outlook is weak, amid soft nonresidential construction growth and near-peak levels for U.S. light-vehicle sales. Based on our outlook, every U.S. steelmaker we cover is trading above fair value.

The long-term outlook is similar for aluminum, where we expect lower Chinese demand growth and chronic overcapacity to stymie progress toward a sustained aluminum price recovery. Weaker Chinese demand growth will prove insufficient to absorb the industry's massive overcapacity and excess inventories. This is critical, as China accounts for half of global aluminum demand and has consumed more than 90% of incremental demand over the past decade. Low-cost supply additions will also ensure that structural overcapacity remains. Our midcycle aluminum price forecast points to a roughly 10% decline from current levels. Accordingly, each aluminum company we cover is trading below our estimate of fair value.

By early September, gold had remained stuck in the mid-$1,300 range, as the U.S. Federal Reserve wavered between increasing the fed-funds rates sooner or later. In August, during the central bank's annual retreat, Federal Reserve members sounded more bullish on the U.S. economy, as rhetoric supportive of rate increases strengthened. Yet immediately after a disappointing August jobs report, uncertainty on when the Fed will again raise rates returned.

While trying to guess the timing of the Fed's moves remains as cloudy as ever, we continue to believe that more rate hikes are coming (as soon as the end of this year), which bodes poorly for gold. As interest rates increase, the opportunity cost of holding gold will increase, triggering a reversal of recently robust investor flows into the yellow metal. Compounding matters, a reversal in flows means yesterday's demand becomes tomorrow's oversupply. We regard most of our gold miner coverage as overvalued, though not as much as we do industrial commodity miners.

Among the macroeconomic drivers most relevant to materials stocks, we remain bullish on U.S. housing. Although we've continued to see momentum in homebuilding activity, the first half of 2016 didn't measure up to our expectations. Property vacancies have continued to contract well beyond our expectations, absorbing between 125,000 to 140,000 starts in 2016. This has weighed on total demand for new homes during the year, leading us to reduce our forecast for housing starts to 1.19 million in 2016, down from 1.22 million.

However, our decadelong outlook for housing remains bright. An impending surge in housing demand from the millennial generation will drive substantial construction activity through 2020. Falling housing vacancies should drive house prices and rental rates higher, encouraging builders to ramp up activity in 2017 and beyond.

We continue to believe lumber producers will prove the best way to play resurgent housing demand. With North American capacity nearly 90% utilized, growing housing demand remains poised to drive profitability higher for

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The recent bumper crop of seed and chemical deals is poised to reshuffle the industry. In contrast to emerging consensus, we doubt that the integrated seed-chemical model will strengthen competitive advantages. We see limited opportunities for cross-selling and research-and-development synergies that would strengthen moats, given the differences inherent in the seeds and crop chemicals businesses. Any R&D synergies, in our view, would be many years down the road. Still, we don't view the deals as value-destructive, as they occur amid a cyclical trough for the industry and at fairly depressed share prices. Further, the deals are likely to derive at least some value from cost synergies.

With Monsanto finally accepting Bayer's purchase offer, antitrust regulators have a full plate of seed and crop chemical tie-ups to review. With several potential deals being considered together, we think the probability that each of the deals will be approved has decreased compared with a scenario where each deal faces the regulatory bodies on its own.

Even so, we think it's more likely than not that all of the deals currently on the table--Bayer's purchase of Monsanto, the merger between

Cameco

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Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: CAD 23.00

Fair Value Uncertainty: High

Consider Buying: CAD 13.80

Cameco produced 27.2 million pounds of uranium in 2015, making it one of the world's largest uranium producers. The flagship McArthur River mine in Saskatchewan accounted for 50% of output. Cameco intends to increase annual uranium production substantially over the next several years. In addition to its large uranium mining business, Cameco owns a uranium marketing business and operates uranium conversion and fabrication facilities.

Shares of blue-chip uranium miner Cameco have fallen in concert with the rest of the mining sector over the past two years, losing roughly 50% of their value in the process. Cameco's sympathetic sell-off affords investors an attractive entry point into one of the last remaining China-led commodity growth stories. While China's structural slowdown will continue to weigh on the mining industry's main moneymakers--copper, coal, and iron ore--the country's uranium demand is set to quadruple over the next decade. We expect Cameco to outperform mining industry peers over the next several years as impending uranium supply shortfalls catalyze higher prices and a rerating of Cameco shares.

Canfor

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Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: CAD 25.00

Fair Value Uncertainty: High

Consider Buying: CAD 15.00

Canfor is a softwood lumber company that also owns around half of Canfor Pulp. It is active throughout North America, with lumber mills in British Columbia, Alberta, and the southeastern United States.

We like Canfor for its leverage to U.S. housing. Rising housing starts should lead lumber demand higher, driving up industry capacity utilization, and with it, prices. Our bullish housing outlook is predicated on the notion that tighter labor markets and improved mortgage availability will unleash enormous pent-up demand from the extended housing bust. Canfor is particularly attractive in light of recent poor share price performance, which is disconnected from fundamentals. As of Sept. 20, shares are down 45% from June 2015. Meanwhile, framing lumber prices are up 13% from the same period last year. As momentum continues to build for U.S. housing, we see nearly 85% upside in the stock.

Compass Minerals International

CMP

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $89.00

Fair Value Uncertainty: Medium

Consider Buying: $62.30

Compass Minerals produces two primary products: salt and sulfate of potash, a specialty fertilizer. The company's main assets include rock salt mines in Ontario, Louisiana, and the United Kingdom and salt brine operations at the Great Salt Lake in Utah. Compass' salt products are used for deicing and also by industrial and consumer end markets. The firm's fertilizer products are used by growers of high-value crops that are sensitive to standard potash.

After a couple of mild winters in Compass' important U.S. Midwest markets, the company's profits have been dented, and high customer inventories darken the near-term outlook for salt volumes and pricing. However, over the long run, we think a return to more normal snow in the Midwest, and thus more normal salt volumes for Compass, will help catalyze a rebound in shares. Further, we think the market may be underappreciating the company's ability control unit costs, as recent capital improvements at Goderich are set to put a lid on the Compass' future salt costs.

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