Monday's ISM Manufacturing Report offered some interesting insight into the basic materials sector. Indeed, The Report that Shook the World led me to advise investors to review their high-beta cyclical and industrial sector shares. Here's why I think investors must shed basic materials stocks dealing in industrial commodities too.
One very important insight from the ISM report, one that was also found within the prior month's report, has me vehemently calling for the sale of basic materials shares that deal in industrial commodities. The report showed manufacturers paid much lower prices for raw materials in June. The Prices Index fell 10.5 points, to 37.0 in June, indicating a faster rate of decreasing prices, a trend that began the month before. One respondent to the survey was quoted as saying, "Significant raw materials price correction under way."
The income of basic materials providers of industrial commodities is closely tied to the prices of those commodities. The iShares Dow Jones US Basic Materials (NYSE: IYM) security has been on a correction trend since the beginning of the year though, as the deflation news is no secret. It's been best illustrated by the decline in oil prices of late, with the United States Oil (NYSE: USO) down 21.7% since May 1st. It's likewise been seen in the producers of industrial commodities.
Alcoa (NYSE: AA) reports earnings in about a week, kicking off earnings season, and I'm suggesting investors sell it and similar shares. Yet, these stocks have already compensated a good deal for lower pricing and lighter global demand. AA has been on a correcting trend since the beginning of the year in fact, and so its actual results could be better than the bad news implied by the shares' correction to date.
Historical P/E-5 Yr Ave
BHP Billiton (BHP)
Rio Tinto (NYSE: RIO)
Vale S.A. (NYSE: VALE)
Freeport-McMoRan (NYSE: FCX)
In terms of valuation, many of these names have P/E ratios deeply discounted to their historical P/Es of the last five years. Some, like VALE also offer well fattened dividend yields. However, as a seasoned analyst, I came to learn that there's often a good reason for what may appear to be value. We might want to take a more focused look at some of these names in future reports to better vet their valuations. Alcoa does not look cheap though, and neither does Rio Tinto. Moving forward, the outlook for Alcoa , BHP Billiton , Rio Tinto , Vale S.A. and Freeport-McMoRan Copper & Gold could very likely disappoint. For this reason, and even independent of valuation, investors will probably be better served with their capital placed elsewhere; it's just not worth the risk in my opinion.