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Outperforming Basic Materials Leaves Few Bargains

Opportunities in green hydrogen could benefit industrial gas companies.

The Morningstar US Basic Materials Index outperformed the broader market during the first quarter of 2021 by 615 basis points.

U.S. materials index versus U.S. equity index - source: Morningstar

Trailing one year, the materials sector has massively outperformed by more than 2,380 basis points compared with 185 basis points of underperformance a quarter ago. As a result of the rally from the depths of the pandemic, just two U.S. basic materials stocks we cover now trade in 4-star territory, and no stocks trade at 5 stars.

Less than 10% of materials stocks trade at attractive discounts - source: Morningstar

Industrial gas firms’ sales held up well in 2020 despite COVID-19. Their resilient on-site businesses benefit from long-term customer agreements with fixed fees and take-or-pay clauses. We expect the sector to benefit from a rebound in merchant volumes in 2021, continued growth in the electronics end market, and strong demand for medical gases. Furthermore, we believe that industrial gas companies are well positioned to capitalize on new opportunities in green hydrogen.

Chemicals producers saw demand continue to recover to begin the year following COVID-19-driven closures. We expect a continued sequential volume recovery through 2021. In specialty chemicals, we see long-term growth for companies in electric vehicles. EVs require more electronic materials and typically use more polymers to make the vehicles lighter, which allows specialty chemicals producers to generate more revenue per vehicle. As EVs reach cost and functional parity with internal combustion engines, we expect adoption to increase from 4.4% in 2020 to 20% in 2030.

We forecast 20% global EV adoption by 2030 - source: Morningstar

Deicing salt prices will fall for the 2020-21 winter following a mild 2019-20 winter. Deicing salt demand volume is driven by winter weather. As such, prices tend to fall following a milder winter as producers carry excess inventory, leading to oversupply conditions. While weather is volatile each year, it tends to revert to the mean over a longer period. The 2020-21 winter snowfall has been slightly above average so far. Combined with reduced supply from a mine closure, we expect prices to rise in the 2021-22 season.

Snowfall volatility has increased over time - source: Morningstar

Top Picks

Air Products & Chemicals APD Star Rating: ★★★ Economic Moat Rating: Narrow Fair Value Estimate: $297 Fair Value Uncertainty: Medium

Because of question marks around Jazan and Lu’An, market sentiment has turned negative on narrow-moat Air Products, and we see shares as modestly undervalued. Given lower expectations, as it looks like consensus numbers now exclude any EPS contribution from Jazan, we think that any favorable news on either project could be a positive catalyst for the stock. Despite near-term headwinds due to COVID-19 and the two gasification projects, we remain optimistic about the long-term outlook for Air Products, including investment opportunities in green hydrogen.

DuPont DD Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $90 Fair Value Uncertainty: Medium

Our top pick to play specialty chemicals demand growth is narrow-moat DuPont. The stock trades in 4-star territory at roughly a 15% discount to our fair value estimate. DuPont is well positioned to benefit from greater adoption of electric vehicles, as the company generates roughly 50% more revenue per EV compared with an internal combustion vehicle. Further, DuPont should see growing demand from other underlying trends, including the growth of 5G-enabled devices and a recovery in U.S. housing starts. We think the current share price is an attractive entry point.

Compass Minerals International CMP Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $78 Fair Value Uncertainty: High

Wide-moat Compass Minerals is our top pick to play a rebound in deicing salt prices, trading in 4-star territory at roughly a 15% discount to our $78 fair value estimate. Compass’ cost advantaged salt production stems from its Goderich mine, which also benefits from being on Lake Huron, allowing it to both produce and transport at a lower cost than competitors. Although Compass has seen higher costs in recent years owing to temporary operational issues, unit costs have since fallen, and we expect further declines over the next couple of years as operation is fully restored.

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