Basic Materials: Valuations Propped Up by Shaky China Fundamentals

• On a market capitalization-weighted basis, our basic materials coverage trades at a 37% premium to our estimate of intrinsic value, making it the most expensive sector we cover.
• Miners we cover are generally substantially overvalued and few trade in line with our fair value estimates, reflecting our expectation for a structural change in demand growth from China as its economy matures and transitions toward less commodity-intensive and more consumption-driven economic growth.
• Gold is among the few mined commodities that isn't directly tied to the fortunes of Chinese fixed asset investment, but as the Federal Reserve continues to pursue rate increases, prices look primed to fall.
• Two of the four big deals in the agriculture industry were consummated in the third quarter (ChemChina's acquisition of Syngenta and the Dow-Dupont merger), with the remaining two (Potash-Agrium and Bayer-Monsanto) likely to receive regulatory approval and close within the next 12 months.
• Despite temporary hiccups, U.S. construction activity continues to build momentum; the long-term outlook remains bright for lumber and aggregates companies hitched to this wagon.

With few exceptions, we continue to see mined commodity and miner share prices as overvalued, propped up by Chinese stimulus. Iron ore's relative buoyancy since early 2016 is emblematic of most industrial commodities. The steelmaking ingredient's Indian summer continued into July and August. The iron ore price rose from $63 per metric ton at the start of July to peak just shy of $80 per metric ton in August, despite record and rising iron ore port stockpiles. Recent conditions have been highly favorable for miners, particularly the bulk miners, as exemplified by our forecast 2017 adjusted earnings for

We do not expect this to last. With China's credit growth slowing, we continue to expect mined commodity prices in general, and particularly iron ore, to fall materially and for share prices to follow. Miners we cover are generally substantially overvalued, and few trade in line with our fair value estimates. This reflects our expectation for a structural change in demand growth from China as its economy matures and transitions toward less commodity-intensive and more consumption-driven economic growth. High-cost miners and those with outsized exposure to iron ore and coking coal tend to be most overvalued.

Iron ore's shaky fundamentals were laid bare via a sell-off in the wake of the U.S. Federal Reserve's Sept. 20 announcement that it would begin to trim its balance sheet in October and would likely hike rates in December. Prices dropped 7% to $63 in response, continuing a sell-off that had begun a week prior.

Aluminum has fared better than iron ore in the closing days of September, with spot prices on Sept. 20 reaching their highest level since 2012. Prices have moved higher because of better-than-expected aluminum demand as well as the perceived benefits of capacity reductions in China.

We believe investors have become overly enthusiastic on both counts. We forecast a significant deceleration in aluminum demand growth and anticipate that the impact of capacity cuts will prove far overstated. Accordingly, we forecast a long-term aluminum price of only $1,475 per metric ton (in real terms), nearly 30% below current levels.

Our long-term midcycle price forecast, to be achieved by 2021, sits 18% below the Metal Bulletin consensus outlook of $1,790 per metric ton (in real terms), which is based on the published figure just above $2,000 (in nominal terms). A price decline of this magnitude would have a substantial impact on share prices for

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On the demand side, the key factors underpinning our bearish outlook are our below-consensus forecast for Chinese fixed-asset investment and fading benefits from China's recent stimulus package. Additionally, we contend that India is still a number of years away from picking up the slack as the next major driver of global aluminum consumption. On the supply side, we expect Chinese structural overcapacity to remain in place, as large swaths of new, low-cost capacity more than offset the country's progress in closing high-cost facilities.

Gold is among the few mined commodities that isn't directly tied to the fortunes of Chinese fixed asset investment. Investor demand continued to drive gold prices higher in the third quarter, reaching more than $1,300 per ounce as of Sept. 20. Geopolitical uncertainty has pushed ETF gold holdings to levels last seen before the December 2016 rate hike.

But as the Federal Reserve continues to pursue rate increases, prices look primed to fall. Although stubbornly low inflation has worried central bankers, market inflation expectations have strengthened in recent weeks, nearing the long-term target of 2%. Additional rate hikes have the potential to unleash accumulated ETF holdings back into the market, raising the opportunity cost of gold ownership and pressuring prices.

Longer term, we're more optimistic, as we expect rising Chinese and Indian jewelry demand to fill the gap of shrinking investor demand for the yellow metal. We see limited opportunities in gold miners, but consider

Two of the four big deals in the agriculture industry closed during the third quarter. ChemChina completed its acquisition of Syngenta, then Dow Chemical and DuPont completed their merger. The newly created

The other two deals are currently undergoing the regulatory review process. The merger between

Residential construction in the United States has remained a disappointment heading into the final quarter of 2017. This is partly a consequence of short-term labor constraints and stagnating rents, which have cooled previously hot multi-family construction. The remainder of 2017 will likely prove to be a mixed bag for North American wood product companies. We expect that volumes could come under pressure amid a bruising hurricane season that has kept laborers off job-sites. In contrast, pricing has remained above $400 per thousand board-feet, in response to additional mill downtime in the Southeast United States.

Over the medium to long term, we remain far more optimistic. As a wave of millennials age deeper into their 20s and 30s, demand for housing is set to rise substantially. As families form, young adults become more likely to live independently. A combination of restrictive trade policies implemented by the Trump administration and already stretched North American lumber, and panel capacity will lead product pricing far higher in the coming decade, as supply struggles to keep up with rising demand. This will lift cash flows for lumber companies

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While U.S. nonresidential construction activity has remained strong, U.S.-focused aggregates and concrete share prices have declined, as optimism for a Trump infrastructure plan has waned. However, we think this decline is unwarranted, as strong underlying demand continues to drive gains in volumes, price increases, and margin expansion. We see value in

Top Picks

Cameco

TSE: (

)

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: CAD 22.00

Fair Value Uncertainty: High

5-Star Price: CAD 13.20

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 decade-long 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 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% by 2025, 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 $30 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: $84.00

Fair Value Uncertainty: High

5-Star Price: $50.40

Compass Minerals produces two primary products: deicing 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 geological and geographical advantages. The company also sits toward the low end of the cost curve in specialty 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 is more likely than not, and thus more normal salt volumes for Compass will spark a rebound in the 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 reduce Compass' future salt expenses on a unit production basis.

Martin Marietta

MLM

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $261.00

Fair Value Uncertainty: High

5-Star Price: $156.60

Martin Marietta's share price has fallen in recent months amid challenging weather and waning optimism for a Trump infrastructure plan, creating an attractive entry point. Despite near-term challenges, the outlook for construction activity for residential, nonresidential, and road projects remains strong. As a result, we expect Martin Marietta's EBITDA to surge 150% by 2021, as strong demand drives higher volume and supports robust price increases. A recovery in construction activity is still in the early stages, as U.S. aggregates consumption remains below prerecession levels. Moreover, current demand doesn't include the backlog of projects created from the recession and years of underspending on infrastructure. Historically, limited funding has prevented this demand from being unleashed, but we think the money will be there due to medium-term funding through the FAST Act and bipartisan support for infrastructure that should deliver longer-term funding.

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