Basic Materials - Do You Have Sufficient Exposure?

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Includes: CTVA, DOW, MERC, RTM
by: George Fisher
Summary

To match the S&P 500 Index allocation, investors should have $27,000 invested in material stocks for every $1 million in an equity portfolio.

There is an abundance of basic material choices, including for income seekers, with 13 distinct industries.

My basic materials portfolio consists of a cross section of industries: pulp and lumber, industrial metals, commodity chemicals, and agriculture seeds and crop protection.

The basic materials sector is often overlooked by many investors. Cyclical in its stock movements, many investors ignore the segment as being too small or not right for their investing acumen. Within the 11 industrial segments, basic materials comprise the smallest sector exposure in the S&P 500 (SPY) with a 2.7% sector weighting. Within an equal weighted portfolio, basic materials should comprise a 9.1% sector weighting. If you managed a $1 million equity portfolio, the basic materials sector allocation would contain a minimum of $27,000 to mirror the overall SPY weighting. Over the years, the basic materials sector has ranged from its current 2.7% SPY weighting to as much 3.2% in 2013.

What are basic materials? The basic materials sector incorporates a wide range of commodity-related manufacturing industries. Included in this sector are companies that manufacture construction materials, glass, paper, forest products and related packaging products, and chemicals. Also included are metals, minerals, and mining companies, including producers of steel. Many basic material companies are engaged in the extraction, processing, and trading of various natural resources, and these firms could be considered as offering an indirect commodity exposure.

Basic materials include many distinct products and commodities, from corn to steel, lumber to cement

Investors have plenty to chose from. There are 276 stocks, 232 mutual funds, and 29 ETFs listed in the basic material sector. As with many funds and ETFs, there are broad-based, diversified materials portfolios and very narrow, industry-focused selections. Many broad-based ETFs will offer mostly matching portfolios, with many recurring names. Several materials ETFs have a specific industry exposure, such as gold miners, rare earth, steel, and timber/forest products. According to etfdb.com, broad-based ETFs have outperformed YTD vs. the majority of industry-specific materials ETFs.

With most basic materials funds and ETFs leveraged to a few names, an equal-weighted portfolio could offer a better balance of names in the sector. Invesco S&P 500 Equal Weight Materials ETF (RTM) offers a balanced portfolio of 27 larger cap stocks with an average 3.75% exposure to each. Compared to the cap-weighted S&P 500 Materials ETF (XLB), RTM has generated a bit higher 5-yr average annual returns. According to dividendchannel.com, a $10,000 RTM investment on June 11, 2014 would be worth $13,606, for a 6.35% average 5-yr annual return, no dividend reinvestment, vs $12,691 for XLB or a 4.88% average annual return.

It should be noted that many of the stocks in this sector are foreign-domiciled and the overall end-user market for this sector is very international in scope. Not only are commodity prices directly affected by the value of the US Dollar in international currency markets, but with a high percentage of revenues generated overseas, the exchange rate will impact revenue and profit conversion for US investors. Investors should note the overall higher risk to currency fluctuations than many other industrial sectors.

What is the current state of basic materials? As one of the more economically sensitive sectors, basic materials are subject to the vagaries of international economic growth. Strong economic growth supports higher volumes and pricing of raw materials. The opposite is also true in that a slowdown of global economic growth has a greater impact on the basic materials sector.

For many commodities, supply of basic materials is in geographic areas of political uncertainty and marginal economic development. As one of the initial and important rungs of a country’s economic development, harvesting natural resources, such as coal, timber, and metals, the sector lends itself to a higher exposure to third-world countries.

As the largest developing country, China’s demand has a huge influence over commodity supply and prices. In several markets, China is the largest buyer of basic materials. Copper, iron, coal and pulp are a few examples of the large exposure many basic material firms have to the Chinese market. The current trade spat between the US and China, coupled with tariffs threats to other trading partners, has pressured sector stock prices over the past month or so. A decline in global economic growth will negatively impact volume, pricing and profitability in the sector.

The latest sector review by CFRA generally outlines the positives and negatives of the sector as:

Positive factors for the materials sector include:

  • Increased demand: Developing countries continue to need more raw materials to support their infrastructure building.
  • Reduction in austerity programs: Reduction in austerity programs: Some global fiscal restraint measures seem to be easing, which could help to stimulate growth.
  • More-accommodative central banks: The Federal Reserve and The European Central Bank both appear to be moving to an easier stance, which could help to support commodities demand.

Negative factors for the materials sector include:

  • Reduction in demand from China: Chinese demand for processed commodities might be slowing as technological advances and a build-out of production facilities allow the country to produce more of its own materials. China recently transitioned from being a net importer to a net exporter of steel.
  • Larger inventories in China: Reports of large supplies could dampen hopes for a sharp rebound, as it could take time to work through those stockpiles.
  • Increased labor costs: Wage costs are rising in the materials sector, as we've seen skilled-labor shortages in certain segments of the market.
  • Trade concerns: If current trade disputes escalate into a full-blown trade war, the globally involved materials sector could be hurt.

The S&P offers a host of quarterly spreadsheets on its Index performance by sector. According to their latest data of June 6, large cap materials stocks traded at an average PE 18.0 with a projected annual EPS growth rate of 10.7%, calculating a PEG ratio of 1.70 Mid-cap materials stocks traded at a slightly lower valuation with a PE of 13.1, a growth rate of 10.0%, and a PEG ratio of 1.30. Small-cap material stocks were trading at a PE of 14.8, a growth rate of 11.9%, and a PEG ratio of 1.30. While offering a bit more investment risk due to size, currently mid-caps and small-caps material stocks could offer better values than their large capitalization cousins.

According to the folks over at macrotrends.com, there are 13 industries within the basic materials sector. The table below lists these along with a few comparable valuation comparisons.

My portfolio choices. In the past, I have been a big supporter and owner of multiple timber stocks, but only when purchased at the depths of a housing slowdown. I have previously been a shareholder in Georgia-Pacific’s The Timber Company, in Plum Creek Timber and in Canadian TimberWest before they were gobbled up in the timberland consolidation trend. In addition, past timber positions have included Pope Resources (POPE) and Rayonier (RYN) pre- and post-REIT conversion. I like POPE for its unique MLP structure, its timber fund exposure and its exclusive west coast exposure, and RYN has very valuable land assets along the I-95 corridor in the Southeast. When home-builders are jumping out the window and lumber prices have collapsed to 5- or 10-yr lows, these are the two timber stocks I plan on adding once again.

For my current portfolio, I have chosen four companies to generate my basic materials sector exposure: pulp producer Mercer International (MERC), basic metal miner and commodity trader Glencore International (OTCPK:GLCNF) and two recently separated stocks with commodity chemical giant Dow Inc. (DOW) and agricultural-focused Corteva (CTVA). I have full positions in MERC and GLCNF, and am in the process of building long-term holdings in DOW and CTVA, with starter-sized positions currently.

Mercer Int’l is a US-domiciled pulp and lumber manufacturer with factories in Canada and Germany. MERC produces specialty pulp NSBK, northern softwood bleached kraft, used in the papermaking process to strengthen the finished product. The major use is in the manufacturing of tissue and toilet paper, and China is the largest market for NSBK. In addition, MERC manufactures lumber in Germany and was an industry innovator in generating electrical power through its biofuel and wood chip waste.

“Black liquor” chemicals and power generation reduce the cost of operating MERC mills, saving as much as $40 per ton in manufacturing costs, and the company sells excess power to local power companies. MERC has been free cash flow positive every year since 2009, with the exception of 2013. I have been a shareholder since early 2011 and was drawn in through research on its largest shareholder, Peter Kellogg and his IAT Reinsurance Company. MERC has paid a dividend since 2015, and currently yields 3.4%. Consensus EPS for 2019 is $2.64 and for 2020 is $2.84. Credit Suisse is a bit more bullish with earnings estimates over $3.00. Consensus price targets are in the $26 range, reflecting a more normal industry PE of around 10. MERC has a disappointing B- SPGMI rating for 10-yr consistency in earnings and dividend growth.

Glencore Int’s is a bit more controversial. The giant commodity firm has mining interests in many of the most basic industrial metals, such as copper, zinc, cobalt, and iron ore. In addition, GLCNF trades commodities such as crude oil, and has a substantial agricultural business in Canada and Australia. According to statista.com, GLCNF is the largest producer of cobalt with a 29% global market share and the 4th largest miner of copper. In addition to its own mining activities, GLCNF supplements its production with a very active and profitable trading business. GLCNF accounts for 60% of internationally tradable zinc, 50% of internationally tradable copper and 9% of internationally tradeable grains.

Glencore is very controversial with some of its assets in politically dangerous places, such as central Africa. Local business customs are not always as pristine as westerners desire, and management has been snared in a few potential bribery scandals of late. As with many of these inquiries, the ultimate outcome will probably be a slap on the wrist, a substantial fine and a pledge not to do “it” again – whatever “it” was.

I have been a shareholder in GLCNF since late 2012, after coming public about a year earlier. Nibbling on an increasing position in 2013 and 2014, the truck was backed up in late 2015 when prices sank to under $1.25. As prices recovered in 2017 and early, higher cost purchases were jettisoned, the remaining shares create a nice position with an adequately low cost basis. GLCNF pays an annual dividend of $0.20 for a current yield of 6.0%. According to 4-traders.com, GLCNF earnings per share are expected to be $0.34 in 2019 and $0.40 in 2020. Of the 21 analysts following Glencore, 8 rated it as a “buy”, 8 rate it as an “outperform” and 5 rate it as a “hold”.

The breakup of a mega-conglomerate offers the opportunity to add two additional basic materials stocks. Dow Inc. and Corteva are new additions to my basic materials portfolio as they are new to being independently traded. Both are the result of the merger of 122-year-old Dow Chemical and 216-year-old DuPont de Nemours (DD), followed by the combining of overlapping businesses and the subsequent separation into three distinct companies. Two became one became three.

DOW remains a giant in the commodity chemicals field with plenty of international exposure. Current global economic and currency exchange worries are reducing demand, and hence pricing, of several of its product lines. In the 1st quarter, the largest segment, Packaging and Specialty Plastics (48% of revenues) experienced a 15% decline in revenue y-o-y and a decline of 200 bps to its operating EBITDA, Industrial Intermediates and Infrastructure (32% of revenue) and Performance and Materials Coatings (20% of revenues) both experienced a 2% decline in revenue and a 400 bps reduction in operating EBITDA.

Consensus is for 2019 sales and profitability to maintain its 1st quarter trends, with total year revenues of $46-48 billion and earnings per share in the $4.46 range. Of interest to income seekers should be its dividend yield of 6.0%, but DGI investors should not expect much in the way of distribution growth over the first few years as debt reduction and share buybacks could be a priority. 2020 is estimated to be an improvement with consensus eps at $5.36 with an 8% estimated growth potential.

CVTA is an interesting basic materials firm in the agricultural industry and is split between crop protection chemicals (46% of estimated 2019 revenues), and agricultural seeds (54% of revenues). The crop protection chemical business is mainly driven by commodity products, composing 75% of sales vs patented and differentiated products generating 25% of sales. Management’s goal is to equalize the percentage of higher margined chemicals at the expense lower margined commodity products, driving overall segment profitability higher. CTVA’s legacy genetic seed business includes the Pioneer line from DuPont and the Mycogen line from Dow, plus 5 strong regional brands, providing a platform to effectively compete with the other biggie in the seed business, Monsanto, a subsidiary of German behemoth Bayer (OTCPK:BAYZF) (OTCPK:BAYRY).

However, 2019 has been a very difficult year for the crop business. Led by export and trade uncertainties, coupled with extreme Midwest flooding, the overall agriculture industry is currently in turmoil. Some are calling 2019 the “perfect ag storm” – and if so, nibbling on depressed ag stocks could be well rewarded over the next few years. 2020 is expected to a better year with CTVA eps rising from $1.38 anticipated this year to $1.65 next year.

Vastly under-matured and flooded corn field in Shenandoah, Iowa on May 29.

My basic materials portfolio consists of a cross section of industries: pulp and lumber, industrial metals, commodity chemicals, and agriculture seeds. Two produce nice income with over 6% current cash yields. Overall, I have a 6.79% allocation to the basic materials segment in my equity portfolio.

Investors looking to add or expand their basic materials exposure certainly have plenty of options to chose from. However, for many self-directed investors, their portfolio lack sufficient exposure to the what some mistakenly consider a dull and boring sector.

Author’s Note: Please review the disclosures on my profile page.

Disclosure: I am/we are long DOW, CTVA, GLCNF, MERC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.