Nothing Basic About This Quarter for Basic Materials

The Morningstar US Basic Materials Index’s underperformance versus the broader market has increased in 2020. Year to date, the sector has now lagged the Morningstar US Market Index by more than 700 basis points, driving trailing one-year underperformance to nearly 900 basis points.

As a result, more than 70% of the U.S. basic materials stocks we cover now trade in 4- and 5-star territory, with the median stock trading at a 31% discount to our fair value estimate.

The COVID-19 outbreak has caused a dramatic slowdown economywide. However, we think investors can find attractive risk-adjusted opportunities in sectors such as building materials, agriculture, and specialty chemicals, each of which has limited exposure to the macroeconomic deterioration we are witnessing.

Building materials stocks have performed well over the last several years, stemming from a delayed recovery following the Great Recession. Although nonresidential construction may slow during an economic slowdown, infrastructure investment should drive further growth.

For agriculture stocks, we see little demand impact, as our base case for 2020 assumes farmers will still plant crops globally. As such, we continue to expect a significant rebound in U.S. acres planted following 2019's lowest total plantings in over a decade due to flooding. Further, the end of the South American growing season and the beginning of the harvest has so far been underway with few disruptions, and we expect businesses to hold up well for companies that sell ag inputs to South American farmers.

We expect a varying impact from COVID-19 across the chemicals producers we cover. Some companies may even stand to benefit. Specifically, cleaning chemicals used for food-service production will still be needed. Cleaning the "back of the house," such as ovens, grills, fryers, and so on, is still required for a restaurant to remain open even if it just sells takeout and delivery orders. 

Looking forward to first-quarter earnings, we’ll be looking for any signs of certainty in a highly uncertain time. Many companies have already withdrawn 2020 guidance, so concrete details as to how the COVID-19 outbreak is impacting their operations and what the return path to normalcy might look like will be critically useful as we update our profit forecasts.