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Market Decline Leaves Some Basic Materials Stocks Undervalued

Specialty chemicals producers a smart way to play the growth in electric vehicles and 5G technologies.

The Morningstar US Basic Materials Sector Index fared better than the broader market during the first quarter of 2022 by roughly 500 basis points. The index remained flat during the quarter, while the U.S. market index fell nearly 5%. On a trailing 12-month basis, the basic materials sector outperformed the market by 500 basis points. As a result of the market decline, we see some opportunities across the sector, with one third of the stocks trading in 4-star territory. However, none trade in 5-star territory.

Exhibit 1: U.S. basic materials index versus U.S. equity index.

- source: Morningstar

Exhibit 2: One third of our basic materials names trade in 4-star territory.

- source: Morningstar

Freshwater costs will continue to rise as demand exceeds readily available supply from shallow groundwater. As a result, water must be sourced from deeper aquifers that require more expensive pumping. This should boost demand for water-management systems, particularly in water-intensive manufacturing operations, such as food and beverage, paper, and steel production.

Exhibit 3: Freshwater costs will rise as demand growth requires more pumping.

- source: Morningstar

Electric vehicle sales will rise. Slightly fewer than 5 million EVs were sold in 2021, but we forecast over 32 million by 2030. Lithium is one of the best ways to invest in greater electric vehicle sales, as all EVs need batteries and all EV batteries require lithium as the energy storage component. Accordingly, as lithium demand grows, higher-cost supply will need to come on line, driving up the marginal cost of production. While lithium carbonate prices are currently elevated because of undersupply, we forecast that they will settle at $12,000 per metric ton, which should allow low-cost producers to generate excess returns.

Exhibit 4: We forecast over 32 million electric vehicles sold by 2030.

- source: Morningstar

We see long-term growth for specialty chemicals producers that sell to the electronics and electric vehicles end markets. "Internet of Things" and 5G technologies and electric vehicles require more advanced semiconductors and electronic components. This allows specialty chemicals producers to sell more content per device or vehicle, generating revenue growth at a mid- to high-single-digit annual average rate.

Top Picks

DuPont DD Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $99 Fair Value Uncertainty: Medium

Our top pick to play specialty chemicals demand growth is narrow-moat DuPont. The stock trades at a more than 20% discount to our $99 fair value estimate. DuPont has been investing heavily in its electronics business. The company acquired Laird Performance Materials in July and plans to close its proposed acquisition of Rogers later this year. DuPont also plans to sell most of its mobility and materials portfolio to Celanese in a deal that should close by the end of the year. This should result in the electronics end market generating most profits going forward. In its legacy water and protection business, DuPont should also benefit from the growth in U.S. housing starts. We view the current share price as an attractive entry point for the quality specialty chemicals producer.

Lithium Americas LAC Star Rating: ★★★★ Economic Moat Rating: None Fair Value Estimate: $45 Fair Value Uncertainty: Very High

Lithium Americas is our top pick to play growing lithium demand from increased EV adoption. The stock trades at a more than 30% discount to our $45 (CAD 57) fair value estimate. Lithium Americas does not currently produce any lithium but is developing three lithium resources that should enter production by the end of the decade, with the first resource entering production later this year. Once all projects are fully ramped, we forecast that the company will become a top-five producer by capacity globally. We reiterate our very high uncertainty rating. However, for investors who can tolerate the volatility, we view the current share price as an attractive entry point.

Ecolab ECL Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $215 Fair Value Uncertainty: Medium

Ecolab is our top pick to play rising freshwater costs, as the company's industrial business should see growing demand for its water-management systems. The stock trades at a roughly 20% discount to our $215 fair value estimate. Ecolab's institutional business, which sells cleaning and sanitation products primarily to restaurants and hotels, should continue to recover from the COVID-19-related slowdown, since its hospitality customers benefit from consumers resuming prepandemic activities such as dining out and traveling.

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