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Quarter-End Insights

Basic Materials: Overpriced, With Significant Downside Ahead for Commodities

Few basic materials stocks currently offer risk-adjusted return potential amid our negative outlook for commodity prices.

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  • On a market-capitalization-weighted basis, our basic materials coverage trades at a 25% premium to our estimate of intrinsic value, remaining the most overvalued sector. Our bearish perspectives on most mining and metals companies are the primary drivers of this.
  • Miners and industrial metals companies we cover remain substantially overvalued, reflecting our expectation of a structural change in demand growth from China as its economy matures and makes the transition toward less commodity-intensive and more consumption-driven growth.
  • Gold is among the few mined commodities that isn't directly tied to the fortunes of Chinese fixed-asset investment, but as the U.S. Federal Reserve continues to pursue rate increases, prices look primed to fall. Higher inflation has buoyed gold prices but should only strengthen the central bank's resolve.
  • Unfavorable weather conditions weighed on first-quarter results for many of the agriculture companies we cover, as a delayed start to the U.S. planting season reduced sales across every crop input category. While seed sales should bounce back in the second quarter, we expect planters to use less total nitrogen and crop chemicals in 2018 as the late start reduces midseason application volumes. However, stronger potash demand outside of North America should more than offset stagnant or slightly reduced demand in North America.
  • The  Bayer (BAYRY) acquisition of Monsanto closed in June after receiving all regulatory approvals. All major agriculture deals from companies under our coverage have now closed.
  • U.S. construction activity has continued to gain momentum during the first quarter, with housing starts following builder confidence higher. However, lumber companies look expensive following short-term supply disruptions. We remain optimistic on long-term infrastructure spending, leading to positive outlooks for aggregate and cement companies.

The Trump administration's imposition of steel and aluminum tariffs made waves early in 2018, driving share prices for steel and aluminum producers sharply higher. Although we've increased our forecasts for near-term U.S. steel prices and the U.S. Midwest aluminum premium, we maintain a negative long-term outlook for both industries. We expect substantial global overcapacity will cause most industrial metals companies to fall short of earning their cost of capital over the decade to come. Additionally, with the tariff program now in place, we contend that all near-term positive catalysts have now been exhausted and we see asymmetrical downside risk due to our outlook that both steel and aluminum prices will decline materially in the years to come.

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 India 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 for both steel and aluminum, as elevated metals prices have created incentive for the addition of new supply.

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 were 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, the miners we cover are substantially overvalued. We expect a structural change in demand growth from China as its economy matures and makes the transition 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 Fed'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. Through the second quarter, however, prices have hovered around $1,300 per ounce.

On the back of weak investment demand, we forecast that gold prices will fall to $1,225 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  Goldcorp (GG) undervalued, as we believe execution risk surrounding its 20/20/20 growth plan is overstated. This plan aims to boost production and reserves while cutting costs by 2021.

Strong global demand for potash should support prices throughout 2018. So far this year, reduced supply has boosted potash prices. In potash, new delays via lower-than-expected potash production from both  Sociedad Quimica Y Minera De Chile (SQM) and K+S have led to a tighter market. We expect this dynamic to continue throughout the year, and we've raised our 2018 potash price forecast to $270 per metric ton. Our long-term price forecast for potash is unchanged at $270 per metric ton.

From a valuation standpoint, potash producers are trading at a larger discount to fair value than the rest of our ag coverage. This is primarily because of our long-term outlook that potash prices will remain flat, in real terms, while we forecast real price declines in nitrogen and phosphate.  Nutrien (NTR) and  Mosaic (MOS) currently offer the most upside based on current prices.

The acquisition of Monsanto by Bayer closed in June after receiving all necessary regulatory approvals. In order to gain regulatory clearance, Bayer had to divest a portfolio of agriculture assets that generated around $2.2 billion in sales in 2017 primarily to  Basf (BASFY).

The seasonally slower first quarter yielded considerable catch-up building activity. Single-family construction has gradually gained momentum, while multifamily activity has strongly rebounded in recent months. We expect total starts to climb nearly 8% in 2018 to 1.3 million units as homebuilders capitalize on buoyant confidence and higher prices.

Over the past year, lumber and panel prices have surged because of short-term supply disruptions. Hurricanes in the Southeast, wildfires in the Northwest, and considerable rail congestion throughout Canada 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, despite industry operating rates falling thus far in 2018. We believe valuations for wood product companies are currently stretched, despite our bullish long-term outlook. As these disruptions ease later in the year, we expect pricing to fall by 20%-30%.

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 (CFP) and  West Fraser Timber (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 declined by more than 10% through the end of April. Since then, shares have started to recover and we still see some upside in the sector. We expect strong underlying demand will continue to drive volume gains, price increases, and margin expansion. We see value in  Martin Marietta Materials (MLM) and  U.S. Concrete (USCR), as current share prices underestimate the significant profit growth to come.

Top Picks

 Cameco (CCJ)
Star Rating: 4 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 May 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: $83
Fair Value Uncertainty: High
5-Star Price: $49.80

Compass Minerals produces two primary products: deicing salt and sulfate of potash, a specialty fertilizer. 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 some 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.

We see multiple near-term catalysts that should boost Compass' salt profits and drive share prices higher. Based on our analysis of more than 120 years of weather history, winter weather exhibits mean reversion tendencies over a multiyear period. After a couple of mild winters in Compass' important U.S. Midwest markets, the 2017-18 winter bounced back with above average snowfall and higher salt demand. Historically, harsher winters have led to increased deicing salt prices as local governments need to replenish inventories. This should provide a much-needed profit boost for Compass. 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
Fair Value Uncertainty: High
5-Star Price: $159

Martin Marietta's share price declined through the first few months of 2017 because of an underwhelming Trump infrastructure plan that lacked specifics. However, we believe this created 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 because of medium-term funding through the FAST Act and bipartisan support for infrastructure that should deliver longer-term funding.

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Andrew Lane does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.