Basic Materials: The Most Expensive Sector We Cover

• On a market-capitalization-weighted basis, our basic materials coverage trades at a 44% premium to our estimate of intrinsic value, making it the most expensive sector we cover.
• Metals and mining stocks look especially expensive. Metals prices have been propped up by a combination of Chinese stimulus and supply cuts, but neither source of strength looks sustainable.
• U.S. housing plays remain among the pockets of opportunity in an otherwise overvalued sector. We expect housing activity will continue to build momentum in the remainder of the year.
• The remaining obstacles to major consolidation within the seeds and crop chemicals industry are likely to be overcome. We expect all three major deals to close this year.

Mined commodity prices remain elevated heading into the second quarter, and we see considerable downside for prices and producer shares. The pricing rally that kicked off in early 2016 has begun to elicit a supply response, with mines previously shut down now coming back on line. We have already begun to see greater production from high-cost producers of bulk commodities. As Chinese demand for these commodities fades following the stimulus-led demand uptick in 2016, we expect significant downward pricing pressure on key industrial commodities such as aluminum, iron ore, met coal, thermal coal, and copper.

This dynamic also weighs on our global steel outlook. At the regional level, U.S. steel stocks have performed especially well in recent months, thanks to investor optimism stemming from a potential infrastructure spending boost and supply-side reform in China. However, we believe the long-term impact of both factors will disappoint relative to the expectations that seem to be reflected by current share prices. We expect Chinese steel demand will soften as the benefits of stimulus measures fade. This will limit the global impact of supply-side reform in China and weigh heavily on steel prices.

Momentum in the U.S. housing market has been promising as we enter 2017. Household formation among younger adults, which has hamstrung the housing recovery thus far, is set to improve as tighter labor markets buoy wages and pull more workers off the sidelines. Meanwhile, new housing supply is changing to meet nascent millennial demand, as homebuilders' mix shifts to affordable starter homes. Housing starts rose to an annualized rate of roughly 1.27 million through February, up substantially from an annualized pace of 1.18 million in 2016. With for-rent and for-sale vacancies below historical norms, housing demand will increasingly rely on the construction of new homes.

Given that new residential construction and remodeling make up roughly half of lumber demand, we expect lumber demand to rise substantially through 2021. As demand drives operating rates higher in North America, we expect higher pricing to substantially increase earnings across wood products companies.

The seeds and crop chemicals portion of the agriculture space is still amid a merger-and-acquisition shakeup, with several big potential deals on the table. State-owned ChemChina has agreed to purchase Swiss agrochemical giant

We think all these deals are likely to close. There just isn't insurmountable product overlap between the seed and crop chemical portfolios of the M&A partners, and we think overlap that does exist will be solved by divestitures. None of these deals has yet gained final regulatory approval, but with recent reports that the EU is set to approve both ChemChina-Syngenta and Dow-DuPont, we think approvals will come this year.

Top Picks

Canfor

(

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Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimates: CAD 22.00

Fair Value Uncertainty: High

5-Star Price: CAD 13.20

We like Canadian lumber producer Canfor for its leverage to U.S. housing. The drivers of lumber demand gained strength in 2016, and should improve further in 2017. U.S. housing starts increased 5% year over year in 2016. Improvement was particularly evident in single-family construction, which rose 10%. (Single-family units require roughly twice as much lumber and paneling as multifamily units.) In 2017, we expect continued improvement, with starts rising roughly 11% to 1.3 million. As housing starts march higher, so too should lumber demand, driving up industry capacity utilization, and with it, prices. We believe operating rates will exceed 90% in 2017 as strengthening household formation drives stronger housing starts and wood product demand. We see real lumber prices exceeding $480 per thousand board feet by the end of the decade, versus $410 today.

Cameco

CCJ

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $18.00

Fair Value Uncertainty: High

5-Star Price: $10.80

We think the market is mispricing narrow-moat uranium miner Cameco. Uranium offers a rare growth opportunity in metals and mining. China's structural slowdown portends the end of a decadelong boom for most commodities--but not for uranium. China's modest nuclear reactor fleet uses little uranium today, but that's set to change in a major way. Beijing is pivoting to nuclear in order to reduce the country's heavy reliance on coal. We believe the market overemphasizes the current supply glut caused by delayed Japanese reactor restarts, and this situation won't last much longer. We expect global uranium demand to grow 40% over the next 10 years, a staggering amount for a commodity that saw near-zero demand growth in the past 10 years. Supply will struggle to keep pace. We believe uranium prices will rise from about $20 a pound currently to $65 a pound (constant dollars), as higher prices are required to spur new mine investment. As one of the largest and lowest-cost producers globally with expansion potential, Cameco should benefit meaningfully from higher uranium prices.

Compass Minerals

CMP

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $91.00

Fair Value Uncertainty: Medium

Consider Buying: $63.70

Compass Minerals produces two primary products: de-icing salt and sulfate of potash, a specialty fertilizer. We think the company has carved out a wide economic moat based on cost advantage, thanks to its massive rock salt mine in Goderich, Ontario, which benefits from both location and geology advantages. The company also sits toward the low end of the cost curve in specialty potash. Following a couple 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 to control unit costs, as recent capital improvements at Goderich are set to put a lid on Compass' future salt costs.

More Quarter-End Insights

Market Outlook: Lofty Valuations Call for Careful Stock-Picking

Video Report: Few Values Left in the Global Stock Market

Economic Outlook: First-Quarter Underscores Slow Growth Expectations

Credit Market Insights: Bond Indexes Perform Well as Spreads Tighten Further

Consumer Cyclical: Still Opportunity in a High-Confidence Environment

Consumer Defensive: Still Thirsty for Growth

Energy: Coming Shale Growth a Major Threat to Oil Prices

Financial Services: Weighing the Strategic Tradeoffs of the Fiduciary Rule

Healthcare: Stock-Picking Increasingly Important as Valuations Rise

Industrials: Solid Fundamentals, but Few Screaming Buys

REITs: Playing Defense in an Uncertain Market

Tech: Overvalued Overall, but Opportunities Remain

Telecom: Firms Strive to Be More Than 'Dumb Pipes'

Utilities: Is There Enough Growth to Offset Higher Interest Rates?