Basic Materials: Metals and Mining Firms Substantially Overvalued

• On a market-capitalization-weighted basis, our basic materials coverage trades at a significant premium to our estimate of intrinsic value, remaining the most overvalued sector. Our bearish perspectives on most metals and mining companies are the primary drivers of this outlook.
• 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 has continued to pursue rate increases, prices have fallen to roughly $1,200 per ounce from roughly $1,350 earlier this year.
• After unfavorable weather conditions weighed on first-quarter results for many of the ag companies we cover, volumes rebounded in the second quarter. Through the first half of 2018, demand for nearly all crop input categories was roughly even with the first half of 2017. Fertilizer, nitrogen, phosphate, and potash prices all rose sequentially during the second quarter amid lower supply, which has supported higher profits. We expect prices for these commodities to remain elevated through the second half of the year.
• While new home construction has softened during the second and third quarter, our long-term outlook remains positive. Builder confidence remains high and demographic conditions are favorable. However, lumber companies look fairly valued following short-term supply disruptions. We remain optimistic on long-term infrastructure spending, leading to positive outlooks for aggregate and cement companies.

Ongoing concerns about a trade war between the U.S. and China continue to affect valuations for industrial metals companies. We expect near-term U.S. steel prices and the U.S. Midwest aluminum premium to remain elevated, as they have been since a flurry of tariffs were enacted around the world earlier this year. However, we maintain a negative long-term outlook for both industries. Substantial global overcapacity will cause most industrial metals companies to generate ROICs below their cost of capital once the pricing environment weakens. Additionally, with the tariff program now in place, we contend that all near-term positive catalysts have been exhausted. Metal margins remain near multiyear highs, marking a period of unusually favorable market conditions that is unlikely to persist.

On the demand side, we maintain a below-consensus forecast for Chinese fixed-asset investment as well as 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 incremental industrial metals consumption on a global scale.

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 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. For coal and iron ore miners in particular, we think the market is pricing in unrealistic future margins and expecting unprecedented supply discipline. Supply discipline likely to be difficult given the low entry barriers, extensive undeveloped resources, ample financial capacity among producers and the industry’s historical record of procyclical investment.

Gold is among the few mined commodities that isn't directly tied to the fortunes of Chinese fixed-asset investment. Amid the Fed's ongoing rate hikes and balance sheet reduction, gold investment in exchange-traded fund holdings continued to decline through the third quarter. As real yields on U.S. Treasuries and other safe-haven asset prices rise, the opportunity cost of holding gold rises. Prices have now fallen to around $1,200 per ounce, down from $1,300 a quarter ago.

On the back of weak investment demand, we forecast gold prices to remain around $1,200 per ounce by the end of 2018. Nevertheless, gold has a promising future, and we forecast the nominal gold price to recover to $1,300 per ounce by 2020. We expect that, over 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 given reliance on brownfield expansions over greenfield projects. This plan aims to boost production and reserves while cutting costs by 2021.  Newcrest Mining (NCM) is also somewhat undervalued, with the market underestimating the potential for incremental improvements at its key Lihir and Cadia mines.

Strong global demand for potash should support prices throughout 2018. So far this year, reduced supply has boosted potash prices. In potash, new greenfield mine delays from  K+S (SDF) and EuroChem and 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 into 2019, and we've raised our 2019 potash price forecast to $300 per metric ton, up from $270 per metric ton in 2018. 2019 prices have already begun to rise as both China and India agreed to 2018-19 potash contract prices of $290 per metric ton. We expect prices above $300 per metric ton to remain intact after 2019. Our 2025 long-term price forecast for potash is unchanged at $310 per metric ton in nominal terms.

From a valuation standpoint, potash producers  Nutrien (NTR) and  Mosaic (MOS) 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 the low-$300 per metric ton range, while we forecast that both Nutrien and Mosaic will reduce potash unit production costs, which should lead to profit growth.

Between April and August, construction softened meaningfully versus the start of the year. Single-family construction remained fairly solid, but multifamily activity slowed down sharply. We expect total starts to climb just over 6% in 2018 to 1.28 million units due to favorable pricing conditions for builders and gradual improvement in household formation.

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. Although the last quarter has seen declines in both panel and lumber prices, we think they could fall further still in the near-term. Prices remain above what we believe will be sustainable for at least another two years. We see limited upside in wood product companies, given their current valuations,, despite our bullish long-term outlook. As these disruptions continue to ease, we expect prices to fall further in 2018.

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 anywhere between 13% to 40% through mid-September. However, we view the share price performance as unwarranted and we see 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),  Vulcan Materials (VMC),  Summit Materials (SUM), and  U.S. Concrete (USCR) as current share prices underestimate the significant profit growth to come.

Top Picks

 Cameco (CCJ)
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 inventory overhang 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 $31 a pound in August 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 International (CMP)
Star Rating: 4
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 expect a rebound in Compass' profits over the next couple of years as the mine has been 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 and this trend will continue as Compass reported deicing salt price increases of roughly 15% for the upcoming winter. This should provide a much-needed profit boost for Compass. Further, we think the market may be under-appreciating 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 has underwhelmed in 2018 as optimism for a Trump infrastructure plan has waned and rising costs have caused some fear for profit growth. 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 more than double 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.