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Basic Materials: Fewer Buying Opportunities Than in Most Sectors

With our long-term metals & gold price forecasts well below consensus, most undervalued basic materials stocks offer only modest risk-adjusted upside.

The Morningstar Global Materials Index has fallen 18% year to date through Dec. 20 (Exhibit 1), with nearly all the decline realized over the past three months, as concerns about global growth amid rising trade tensions have taken hold. The materials sector has soundly underperformed the broader global equity market year to date.

Exhibit 1: Global materials index vs. global equity index

Although the sector had been the most overvalued across our broader coverage for some time, this is no longer the case. The median price/fair value estimate for our basic materials coverage is 0.89, which means most are undervalued. However, only eight stocks in the sector have a 5-star rating, indicating that most undervalued basic materials stocks offer only modest risk-adjusted upside (Exhibit 2).

Exhibit 2: The sector is no longer overvalued, but 5-star stocks are hard to find

We see comparably fewer opportunities in the metals/mining and steel industries, reflecting our expectation for a structural change in demand growth from China as its economy matures and the country transitions toward less commodity-intensive and more consumption-driven growth. Our long-term price forecasts for most industrial metals are well below consensus (Exhibit 3). We're particularly bearish on iron ore, prices of which we expect to fall to $35 per metric ton, in real terms, by 2022.

We are relatively more constructive on the outlook for gold, which is among the few mined commodities that aren't directly tied to the fortunes of Chinese fixed-asset investment. Although we don’t anticipate gold’s investment attractiveness to improve, growth in other demand categories should lead a price recovery to $1,270 per ounce in 2019 and $1,300 per ounce in 2020. We expect Chinese and Indian jewelry demand to fill the gap left by waning investor demand.

Exhibit 3: Our long-term metals & gold price forecasts are well below consensus (2019$).

We see good value in many building materials names. In the U.S., for example, total housing starts are on pace to climb nearly 8% in 2018 to roughly 1.3 million units. We anticipate continued demography-led growth in the years to come (Exhibit 4).

Exhibit 4: We’ve tempered our U.S. housing outlook, but we’re by no means bearish

Top Picks

Compass Minerals International CMP

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $81

Fair Value Uncertainty: High

5-Star Price: $48.60

Wide-moat Compass Minerals is our top pick in the salt and fertilizer space. The stock is currently trading at a nearly 40% discount to our $81 fair value estimate, as the market is concerned that recent operational issues at the low-cost Goderich mine represent a new normal for Compass' earnings power. With no geological issues, we contend that these operational headwinds will prove fleeting and that Compass will grow profits in the years to come as production is restored and unit production costs are reduced.

US Concrete USCR Star Rating: 5 Stars Economic Moat: None Fair Value Estimate: $70 Fair Value Uncertainty: High 5-Star Price: $42

Trading at a 48% discount to our fair value estimate, U.S. Concrete shares are undervalued, even after considering our high uncertainty rating. Consensus largely agrees, as shares trade about 42% below the median price target. Shares traded as high as $84 per share as recently as early 2018 but have since traded off over fears of a slowing economy. Today’s shares now price in not just the end of the construction cycle, but a significant contraction, creating an attractive opportunity for investors.

Cameco CCJ Star Rating: 5 Stars Economic Moat: Narrow Fair Value Estimate: $19.50 Fair Value Uncertainty: High 5-Star Price: $11.70

Amid uranium oversupply, Cameco and the Kazakhstani nationally owned company curtailed production, helping reduce stocked inventory. Meanwhile, demand continues to grow as China brings more nuclear reactors on line. Uranium price recovery has accelerated through the end of 2018, with the consensus view that little recovery remains. We disagree, as the still-improving supply-demand balance will help drive better uranium prices, allowing Cameco to return to full operation at good margin.

Exhibit Sources: Morningstar, government agencies, the Federal Reserve. Data as of Dec. 20, 2018.

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