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Basic Materials: Few High-Upside Investment Opportunities

Basic materials stocks have soundly underperformed the global index.

The Morningstar Global Materials Index has underperformed the broader market over the trailing one-year period, in part because of growing concerns about global growth amid rising trade tensions.

Global Materials Index vs. Global Equity Index - source: Morningstar Analysts

Within the basic materials sector, not a single stock is trading in 5-star territory. We see some upside across our agriculture and building materials coverage, but opportunities in other industries are few and far between.

Sector is no longer overvalued, but there are no 5-star stocks - source: Morningstar Analysts

Metals/mining and steel are two of the most overvalued industries, reflecting our expectation of 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 iron ore price forecast is well below consensus.

We are bearish on iron ore but bullish on uranium/lithium. - source: Morningstar Analysts

A slower near-term path for interest-rate hikes has bolstered gold’s investment attractiveness, buoying gold prices in late 2018 and early 2019. Gold prices are now roughly in line with our forecast of $1,270 per ounce in 2019 and $1,300 per ounce in 2020.

Through the end of 2018, uranium spot prices rose more than 20% to roughly $28 per pound. Although consensus and market-implied prices suggest little recovery left, we disagree. We believe production discipline will continue to help address industry oversupply, leading to a recovery of prices to $65 per pound by 2021.

We maintain a bullish outlook for lithium. We forecast lithium carbonate prices will decline modestly to $12,000 per metric ton (on a Chilean export basis). However, our outlook is well above consensus-implied prices of $10,000, largely because of our global electric vehicle adoption forecast of 15% by 2028 versus 11% consensus.

After a slowdown in new-home construction and existing-home sales, housing-related stocks have sold off. In our view, recent pessimism around both housing and lumber prices has provided long-term investors with some attractive buying opportunities. While the path to more homebuilding will be gradual, we expect fundamentals to strengthen as student debt burdens lessen and incomes rise among millennials.

New-home construction has room to run, but progress will be gradual. - source: Morningstar Analysts

Top Picks

Compass Minerals CMP

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $81

Fair Value Uncertainty: High

Wide-moat Compass Minerals is our top pick in the salt and fertilizer industry. The stock is 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 and production rates continuing to improve, we contend that these headwinds will prove fleeting and that Compass will grow profits in the years to come as the mine is fully restored and unit production costs are reduced.

Cameco CCJ

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $19

Fair Value Uncertainty: High

Although Cameco has continued to purchase uranium at a higher price than its own unit costs of production, this strategy has helped reduce market oversupply. Meanwhile, demand continues to grow as China brings more nuclear reactors on line. Uranium prices have stayed somewhat flat through the end of 2018 and into 2019, with the consensus view that little upside remains for prices. We disagree, as the still-improving supply/demand balance will help drive higher uranium prices, allowing Cameco to eventually resume full operations at more attractive margins.

Sociedad Quimica Y Minera De Chile SQM

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $64

Fair Value Uncertainty: High

Narrow-moat SQM is our top pick in the lithium industry. The stock is trading at a nearly 40% discount to our $64 fair value estimate, as the market is concerned about lower lithium prices weighing on future company profits. However, we contend that higher lithium prices will be needed to incentivize lower-quality supply in order to meet demand from growing electric vehicle adoption. With the lowest-cost lithium carbonate production globally, SQM is well-positioned to grow lithium profits, and we view current share prices as an attractive entry point for a quality lithium producer.

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