Basic Materials: Still Overvalued Despite Protective Tariffs
Our bearish view on the mining and metals sector means the basic materials coverage universe trades at a market-cap-weighted 30% premium to our fair value estimates.
Trump’s imposition of steel and aluminum tariffs made waves early in 2018, leading shares in steel and aluminum producers higher. As we anticipated, these tariffs were structured to contain exemptions for both Canada and Mexico immediately, with likely carve-outs for additional trade partners later. Although we’ve increased our near-term steel price expectations in the United States, we remain bearish over the long run. Substantial global production overcapacity leads us to expect most metals companies to fall short of earning their cost of capital over the decade to come. This leads us to view steel and aluminum producers as considerably overvalued today, despite what may appear to be a positive catalyst.
We forecast a significant deceleration in aluminum and steel demand growth and anticipate that the impact of Chinese capacity cuts will prove far overstated. Accordingly, we forecast a long-term aluminum price of only $1,475 per metric ton (in real terms), roughly 25% below current levels.
A price decline of this magnitude would have a substantial impact on share prices for Alcoa (AA), Norsk Hydro OSL: NHY, Chalco (ACH), and Alumina ASX:AWC, each of which is trading well above our fair value estimate.
On the demand side, the key factors underpinning our bearish outlook are our below-consensus forecast for Chinese fixed-asset investment and fading benefits from the Chinese stimulus. While some may look hopefully upon India to pick up the slack, we believe it remains several years away from being the next major driver of global metals consumption. On the supply side, we expect Chinese structural overcapacity to remain in place, as large swaths of new, low-cost capacity more than offset the country's progress in closing high-cost facilities.
With few exceptions, we still see mined commodity and miner share prices as overvalued, propped up by the sustained Chinese stimulus. Iron ore's relative buoyancy since early 2016 is emblematic of most industrial commodities. Recent conditions have been highly favorable for miners, particularly the bulk miners, as exemplified by 2017 adjusted earnings for Rio Tinto (RIO), which are up nearly ninefold from 2015 levels.
We do not expect this to last. With China's credit growth slowing, we still expect mined commodity prices for products such as copper, iron ore, and alumina to fall materially and for share prices to follow.
Accordingly, we believe the miners we cover are substantially overvalued. We expect a structural change in demand growth from China as its economy matures and transitions toward less commodity-intensive and more consumption-driven growth. High-cost miners and those with outsize exposure to iron ore and coking coal tend to look the most overvalued.
Gold is among the few mined commodities that isn't directly tied to the fortunes of Chinese fixed-asset investment. Despite the Federal Reserve’s ongoing rate hikes and balance sheet reduction, gold investment in exchange-traded fund holdings remains as high as it did when rates were meaningfully lower. As real yields on U.S. Treasuries and other safe-haven asset prices rise, the opportunity cost of holding gold will rise. Yet during the first quarter, prices have remained above $1,300 per ounce.
On the back of weak investment demand, we forecast gold prices to fall to $1,150 per ounce by the end of 2018. Nevertheless, we still believe gold has a promising future, and we forecast the nominal gold price to recover to $1,300 per ounce by 2020. We expect that in the long term, Chinese and Indian jewelry demand will fill the gap left by waning investor demand. However, the rise of consumer demand will take time, which points to downside risk in the near term. Although we see limited opportunities in gold miners, we consider Eldorado Gold (EGO) undervalued, given the ongoing challenges in its critical Greek expansion projects.
The one outstanding agriculture deal, the acquisition of Monsanto (MON) by Bayer (BAYRY), is still under regulatory review by U.S. and European regulators. As a response to the European Commission’s concerns about the merger, Bayer has agreed to sell a portfolio of seeds and crop chemical products to BASF (BASFY) for roughly $9 billion in two separate transactions. Although Bayer may need to divest itself of more agriculture assets to receive U.S. approval, we think the deal will ultimately clear all regulatory hurdles. We still expect the acquisition to close in 2018.
Likewise, DowDuPont (DWDP) is preparing to separate into three businesses following its merger last year. The materials science business will retain the Dow name, the specialty products business will retain the DuPont name, and the agriculture business will be known as Corteva Agriscience. We expect the demerger to be completed in 2019.
The seasonally slower fourth and first quarters have yielded considerable catch-up building activity. Single-family construction has continued to gain momentum, while multifamily activity has remained stable on average. We expect total starts to climb nearly 8% in 2018 to 1.3 million units as homebuilders capitalize on buoyant confidence and rising prices.
Over the past six months, lumber and panel prices have surged due to short-term supply disruptions. Hurricanes in the Southeast, wild fires in the Northwest, and considerable rail congestion in British Columbia have reduced the amount of product coming to market. This has launched prices beyond what we believe will be sustainable for at least another two years, and we believe valuations for wood product companies are stretched despite our bullish long-term outlook. As these disruptions ease later in the year, we expect pricing to fall by up to 20%.
However, our long-term outlook for housing is bright. In the wake of the Great Recession, adults in their 20s and 30s are living with family to record-setting ages. We expect them to eventually break out on their own as they begin to form families, driving greater demand for homebuilding. A combination of restrictive trade policies implemented by the Trump administration, an already-stretched North American lumber market, and constrained panel capacity will lead product pricing higher in the coming decade, as supply struggles to keep up with rising demand. This will lift cash flows for lumber companies Canfor TSE:CFP and West Fraser Timber TSE:WFT and panel companies Norbord (OSB) and Louisiana-Pacific (LPX) .
Although U.S. nonresidential construction activity has remained strong, U.S.-focused aggregates and concrete share prices have been largely flat. The long-awaited announcement of Trump’s infrastructure plan, particularly its lack of detail, did little to help market concerns. However, we think shares are undervalued, as strong underlying demand continues to drive gains in volume, price increases, and margin expansion. We see value in Vulcan Materials (VMC) and Martin Marietta Materials (MLM), as current share prices underestimate the significant profit growth to come, in our view.
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $17
Fair Value Uncertainty: High
5-Star Price: $10.20
We think the market is mispricing narrow-moat uranium miner Cameco. Uranium offers a rare growth opportunity in metals and mining. China's structural slowdown portends the end of a decade-long boom for most commodities, but not for uranium. China's modest nuclear reactor fleet uses little uranium today, but that's set to change in a major way. Beijing is pivoting to nuclear to reduce the country's heavy reliance on coal.
We believe the market overemphasizes the current supply glut caused by delayed Japanese reactor restarts, and this situation is easing with production cuts announced by Cameco and NAC KazAtomProm. We expect global uranium demand to grow 40% by 2025, a staggering amount for a commodity that saw near-zero demand growth in the past 10 years. Supply will struggle to keep pace. We believe long-term uranium prices will rise from about $30 a pound in February to $65 a pound (constant dollars) by 2021, as higher prices are required to spur new mine investment. As one of the largest and lowest-cost producers globally with expansion potential, Cameco should benefit meaningfully from higher uranium prices.
Compass Minerals (CMP)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $82.00
Fair Value Uncertainty: High
5-Star Price: $49.20
Compass Minerals produces two primary products: deicing salt and sulfate of potash, a specialty fertilizer. We think the company has carved out a wide economic moat based on cost advantage, thanks to its massive rock salt mine in Goderich, Ontario, which benefits from geological and geographical advantages. The company also sits toward the low end of the cost curve in specialty potash. While the Goderich mine has experienced a couple of near-term operational challenges, we ultimately expect a rebound in Compass' profits as the mine is fully restored and the company's cost-reduction plan comes to fruition.
After a couple of mild winters in Compass' important U.S. Midwest markets, the company's profits have been dented, and high customer inventories darken the near-term outlook for salt volume and pricing. However, this year's winter has seen above-average snowfall, which should buoy near-term volumes. Over the long run, we think a return to more normal snow in the Midwest is more likely than not, and thus more normal salt volume for Compass will spark a rebound in the shares. Further, we think the market may be underappreciating the company's ability to control unit costs, as recent capital improvements at Goderich are set to reduce Compass' future salt expenses on a unit production basis.
Martin Marietta Materials (MLM)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $265.00
Fair Value Uncertainty: High
5-Star Price: $159.00
Martin Marietta's share price was largely flat throughout 2017 and into 2018 amid challenging weather and waning optimism for a Trump infrastructure plan, creating an attractive entry point. Despite near-term challenges, the outlook for construction activity for residential, nonresidential, and road projects remains strong. As a result, we expect Martin Marietta's EBITDA to surge 140% by 2022, as strong demand drives higher volume and supports robust price increases.
A recovery in construction activity is still in the early stages, as U.S. aggregates consumption remains below prerecession levels. Moreover, current demand doesn't include the backlog of projects created from the recession and years of underspending on infrastructure. Historically, limited funding has prevented this demand from being unleashed, but we think the money will be there due to medium-term funding through the FAST Act and bipartisan support for infrastructure that should deliver longer-term funding.
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Charles Gross does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.