The basic materials sector has not been performing well, as a result of a global financial malaise (especially the eurozone crisis and slow economic growth in China), high correlations of some industries (like copper and aluminum), a dip in construction activity (negatively impacting steel and iron ore), and the volatilities associated with the related commodities (e.g. gold, silver).
Recently, a hedge fund, Passport Capital LLC (which has a high exposure in materials sector), has closed its materials fund after a 31% loss this year. Amidst such an uncertain environment, we think this capitulation is a signal of a potential bottom in this sector and is giving an incentive of a possible entry point.
We have recommended a portfolio of four stocks in this sector that we feel have a potential upside and limited downside. This is because this portfolio's stocks are generally the best performers in their respective industries, despite the overall sector's slowdown. Hence, these are the best stocks to bet on a recovery in the materials sector, without taking substantial risk.
Chemicals: DOW Chemical Co. (DOW)
The U.S. Chemical Industry has been able to obtain feedstock advantage, as a result of the shale gas boom. This is because the gas-based raw material ethane is now proving cheaper than oil-based naphtha, in the manufacture of ethylene, which is a very important chemical. DOW Chemical's high dividend and free cash flow yields, diversified product mix, upcoming innovative and value-add products, and relatively inexpensive valuations make it our favorite pick among the Chemical Industry's stocks. Its EV/EBITDA ratio of 9x and forward price-to-earnings ratio of 10x are one of the lowest among peers.
Fertilizers: CF Industries Holdings, Inc. (CF)
CF Industries is one of the best performing companies in the Fertilizer Industry due to its high nitrogen exposure, an increase in its production as a result of low natural gas prices, strong operating performance, and its extensive distribution and storage network. Especially, the current U.S. Midwest drought has been beneficial for fertilizer companies in general and CF Industries in particular, due to a yield cut and price increase of corn, and the resultant increase in fertilizers' demand. As we stated in our previous article, one bushel of grain corn requires 1.4 lbs of potash, 1.25 lbs of nitrogen, and 0.6 lbs of phosphate. So, CF Industries is one of those companies that are expected to benefit the most from a decline in corn yields.
To learn about the dynamics of the Fertilizer Industry, please click here.
Gold: Barrick Gold Corporation (ABX)
Barrick Gold has started to refocus on its principal commodity (Gold), plans to finish a capital cost and schedule review in 2Q 2012, gives high dividend yields (>2%), and has started to emphasize on high-return growth projects. All this are positives for a possible buy position in Barrick Gold, along with the fact that it is currently trading at cheap valuations, with its forward price-to-earnings ratio of ~7x and EV/EBITDA of ~6x. Plus, gold's demand is expected to surge because of high demand from central banks in emerging markets, a possible worsening of the U.S.-Iran crisis, an increase in Chinese and Indian jewelry demand, positive seasonality for Q3 and Q4, and expectations of further steps for monetary stimuli by the world's leading economies.
Please go to our previous article for a detailed overview of the Gold Industry and its major stocks.
Steel: Nucor Corporation (NUE)
Nucor is our favorite among steel stocks because of its exclusive rights over its cost-efficient Castrip technology, efficacious strategic alliances, high dividend yield (almost 4%), its emphasis on environmental protection, and the use of scrap steel. Furthermore, its end markets' demand is expected to improve. Automotive demand is already growing, as is evident from an increase in the seasonally adjusted annual rate (SAAR) of auto sales from 13.9 million in May to 14.1 million in June. Construction demand is currently low, as the Architecture Billings Index declined to 45.8 in May from 48.4 in April. However, we remain bullish on the possible rebound of the Chinese construction sector after the summer season ends. The measures taken by the U.S., Europe, and China, to spur the global economy - like interest-rate cuts and quantitative easing - are likely to increase steel demand and trigger this industry's recovery.
For an overview of other steel stocks, please click here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.