Basic Materials: Propped Up and Too Expensive

• On a market-capitalization-weighted basis, our basic materials coverage trades at a 24% premium to our estimate of intrinsic value, making it the most expensive sector we cover.
• Mining shares have faltered as the effect of China's stimulus has waned, but most still look expensive; so, too, do U.S. steel stocks, which had enjoyed a China-led and Trump-abetted runup.
• We see comparably less downside among gold miners, but we expect rising real interest rates to curtail investor demand for gold in the quarters to come.
• Regulators continue to take a light-handed approach to business combinations in the seeds and crop chemicals industries; each of the three big deals announced in 2016 should close this year.
• Despite temporary hiccups, U.S. construction 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. After a very strong start to the year, the markets for mined commodities have generally softened. Market attention has turned from the tailwind of last year's fiscal stimulus in China and enthusiasm around U.S. President Donald Trump to the headwind posed by structural change and the reduced importance of fixed-asset investment for China's future economic growth.

The second quarter of 2017 saw a meaningful correction in mined commodity prices, particularly for iron ore. The benchmark 62% iron ore spot price of $54 per metric ton is down nearly 40% from the buoyant first quarter of $85 per metric ton. With further low-cost additions looming, demand from China likely to be anemic, and port stockpiles at high and still-rising levels, the market continues to look oversupplied longer term. Coking coal has fared better, with the disruption to Australian supply from Cyclone Debbie sending the spot price above $300 per metric ton. However, spot markets have quickly cooled as supply has recovered, and we now expect long-term drivers to reassert on the market.

For similar reasons, we're pessimistic on steel. Trump's protectionist leanings, highlighted by an announced investigation into whether high volumes of imported steel represent a threat to U.S. national security, have proved to be a boon to steelmaker stock prices in 2017. We contend that weak fundamentals will eventually win out, however, as substantial global overcapacity and decelerating fixed-asset investment in China will weigh on steel prices. As Chinese stimulus measures have tapered, so have steel and steelmaking raw material prices. In the near term, U.S. steelmaker profits should remain attractive, but we see tougher times ahead. Based on our outlook, every U.S. steelmaker we cover is trading above fair value.

Investor demand continues to prop up gold prices at $1,200 to $1,300 per ounce, with ETF gold holdings largely recovered 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. With the 10-year U.S. Treasury now yielding 2.2% and market inflation expectations at 1.8%, real interest rates are in positive territory, raising the opportunity cost of gold ownership. Additional rate hikes by the Fed would further discourage investor flows into gold and has the potential to unleash accumulated ETF holdings back into the market, 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 and caution that even undervalued companies are likely to face near-term headwinds.

Two of the three big pending deals in the seeds and crop chemicals industries moved closer to fruition in the second quarter. After the European Commission's approval, ChemChina announced it had had tendered around 95% of

While we think the Dow-DuPont combination benefits shareholders of both forms, we are somewhat skeptical of management's projected revenue synergies related to the combined agricultural segments, as we see limited benefit from the combination of a seed and crop chemicals operation as GMO seeds have mixed effects on crop chemical demand. For instance, a seed that has been modified to contain herbicide-resistant traits is likely to create greater demand for herbicides, but a seed that has been modified with insect-resistant traits is likely to reduce demand for insecticides. Regulatory approvals of these two deals bode well for

Residential construction in the U.S. lost some steam in the second quarter, but much of the deceleration can be chalked up to a mixture of labor and land constraints rather than demand troubles. We expect activity to rise more rapidly during the second half of 2017, as tighter inventory of existing homes puts upward pressure on pricing, and higher prices induce more homebuilding. With U.S. housing starts running at a pace of 1.19 million units through May, we think there's a far larger recovery ahead, as starts advance to just under 2 million units by 2021.

A rising tide in U.S. housing has helped lift lumber prices, which have trended above $400 per thousand board-feet, up roughly 14% versus the prior year. In part, this has been a function of the recently imposed softwood lumber tariffs, averaging around 20% on the value of lumber shipped to the U.S. from Canada. Given that a substantial portion of lumber consumed in the U.S. originates in Canada, this has lifted North American lumber prices. Although this still has a negative impact on Canadian lumber producers

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), it's partially offset by higher margins on their U.S. operations.

U.S. nonresidential construction has continued to build momentum in 2017. U.S.-focused aggregates and concrete stocks rallied heavily after reporting significant first-quarter gains in volumes, price increases, and margin expansion. Though global cement companies cited similar strength in their U.S. operations, weaknesses in other parts of the globe hamstrung overall results.

We continue to believe that the U.S. construction market has even more growth to come, as housing demand rises and infrastructure repair and improvement activity picks up. Although the Trump administration touted plans for increased spending during its "infrastructure week" in early June, larger political issues stole public attention and weakened the impact of the announcements. In addition, the administration's plans continued to lack sufficient detail, while also still heavily relying on politically polarizing privatization.

Top Picks

Cameco

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Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: CAD 24.00

Fair Value Uncertainty: High

5-Star Price: CAD 14.40

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 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: $88.00

Fair Value Uncertainty: Medium

5-Star Price: $61.60

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 location and geology 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, and thus more normal salt volumes for Compass, will spark a rebound in 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 put a lid on Compass' future salt costs.

Hi-Crush Partners

HCLP

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $17.50

Fair Value Uncertainty: High

5-Star Price: $10.50

Hi-Crush is one of the top four public proppant suppliers, which we collectively expect to supply 54% of all proppant demand in 2020, up from 40% in 2014. This increase can largely be attributed to organic greenfield and brownfield capacity expansion from these lower-cost producers. We expect Hi-Crush to increase its Northern White proppant tons supplied to 7.2 million in 2020 from 4.5 million in 2014. Fears about expanding low-cost frac sand supply have led to an overly negative view on frac sand pricing at the mine, leading to a general undervaluation of frac sand producers. We feel that these fears are overblown, however, given that the recently announced new mines as well as existing sources of regional sand are all confined to a relatively small, unique geographic area. This pattern doesn't portend that a wave of new mines across Texas will push out Northern White supply, as current market pricing seems to indicate.

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