Basic Materials: The Most Overvalued Sector We Cover

• On a market capitalization-weighted basis, our basic materials coverage trades at a 39% premium to our estimate of intrinsic value, making it the most expensive sector we cover. 
• Miners we cover are generally substantially overvalued, 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 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 in the near term.
• We continue to expect the two big deals in the agriculture industry (Potash-Agrium and Bayer-Monsanto) 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. Recent conditions have been highly favorable for miners, particularly the bulk miners, as exemplified by our forecast 2017 adjusted earnings for  Rio Tinto (RIO), which are in line with 2012 levels. 

We do not expect this to last. With China's credit growth slowing, we continue to expect mined commodity prices in general, and particularly for iron ore, to fall materially and for share prices to follow.

The miners we cover are generally substantially overvalued. 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 growth. High-cost miners and those with outsize exposure to iron ore and coking coal tend to look the most overvalued.

Aluminum has fared better than iron ore in recent months, with spot prices revisiting 2012 highs. 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), roughly 25% below current levels.

A price decline of this magnitude would have a substantial impact on share prices for  Alcoa (AA),  Norsk Hydro (OSL: NHY),  Chalco (ACH), and  Alumina (ASX: AWC), each of which is trading well above our fair value estimate.

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 Chinese stimulus. 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. Despite market expectations for a higher federal funds rate as well as the beginning of the central bank’s plan to reduce its balance sheet, gold investment in exchange-traded fund holdings remains as high as it did when rates were meaningfully lower. As real yields on U.S. Treasuries and other safe-haven asset prices rise, the opportunity cost of holding gold will rise. During the fourth quarter, investment demand for gold began to slow and prices fell below $1,250 per ounce from over $1,300 during the third quarter.

On the back of weak investment demand, we forecast gold prices to fall further to $1,150 per ounce by the end of 2018. Nevertheless, we still believe gold has a promising future, and we forecast a nominal gold price of $1,300 per ounce by 2020. We expect that in the long term, Chinese and Indian jewelry demand will fill the gap left by waning investor demand. However, the rise of consumer demand will take time, which points to downside risk in the near term. Although we see limited opportunities in gold miners, we consider  Eldorado Gold (EGO) undervalued, given the ongoing challenges in its critical Greek expansion projects.

Two large deals in the agriculture industry are currently undergoing the regulatory review process. The merger between  PotashCorp (POT) and  Agrium (AGU) has received regulatory approvals in nearly every jurisdiction outside the United States. As a part of the approvals, PotashCorp has agreed to divest itself of its equity ownership stakes in  SQM (SQM), Israel Chemicals, and Arab Potash. In addition, Agrium has agreed to sell its U.S. phosphate operations. We expect the U.S. Federal Trade Commission to finish its review of the deal within the next couple of months and expect the transaction to close by early 2018.

Likewise, the European Commission is reviewing the acquisition of  Monsanto (MON) by  Bayer (BAYRY). The review is expected to be complete by March 2018. As a response to the commission’s early concerns about the merger, Bayer has agreed to sell a portfolio of seeds and crop chemical products to  BASF (BASFY) for roughly $7 billion. Although Bayer may need to divest itself of more agriculture assets, we think the deal will ultimately receive approval. We continue to expect the acquisition to close in 2018.

Short-term labor constraints, stagnating rents, and natural disasters have weighed on homebuilding activity in 2017. As we head into 2018, homebuilding should continue to see momentum grow, albeit less than we were previously expecting. We expect 2018 starts to total roughly 1.3 million, up from just over 1.2 million this year. Although valuations remain stretched for wood product companies today, purchase opportunities may present themselves as lumber prices react to shifting supply and demand.

The next five years still look bright for housing. In the wake of the Great Recession, adults in their 20s and 30s are living with family to record-setting ages. We expect them to eventually break out on their own as they begin to form families, driving greater demand for homebuilding. A combination of restrictive trade policies implemented by the Trump administration, an already-stretched North American lumber market, and constrained panel capacity will lead product pricing higher in the coming decade, as supply struggles to keep up with rising demand. This will lift cash flows for lumber companies  Canfor (TSE: CFP) and  West Fraser Timber (TSE: WFT) and panel companies Norbord (OSB) and  Louisiana-Pacific (LPX). We think the reconstruction of hurricane-damaged homes will be an added tailwind over the next few years.

Although 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 volume, price increases, and margin expansion. We see value in  Vulcan Materials (VMC) and  Martin Marietta Materials (MLM), as current share prices underestimate the significant profit growth to come, in our view. Hurricane damage in key states such as Texas and Florida has weighed on near-term shipment activity but is likely to boost the backlog of repair work, which will strengthen long-term demand.

Top Picks

 Cameco (TSE: CCO) 
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: CAD 22
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 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 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 is easing with production cuts announced by Cameco and NAC KazAtomProm. 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 $27 a pound as of Dec. 4 to $65 a pound (constant dollars) by 2021, 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 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 volume 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 volume 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 Materials (MLM)  
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $263.00
Fair Value Uncertainty: High
5-Star Price: $157.80

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.

Quarter-End Insights

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Energy: A False Sense of Security for Oil Markets
Communication Services: A Deal Eludes Sprint and T-Mobile
Consumer Cyclical: E-Commerce a Key Threat for Some, But Not All
Consumer Defensive: Hungering for Top-Line Gains
Financial Services: Asset Managers Are Forced to Adapt
Healthcare: Pick Carefully as Valuations Head Higher
Industrials: Pockets of Uncertainty Present a Few Opportunities
Real Estate: Slow but Steady Climb Continues
Technology: Most Bellwethers Are Overvalued
Utilities: A Weak December Could Foreshadow a Tough 2018
Venture Capital Outlook: Dry Powder for Late-Stage Deals
Private Equity Outlook: Eyewatering Acquisition Multiples
Crypto Asset Outlook: Installation Phase