Historically, returns for the materials sector and the industrials sector have often moved together, responding to some of the same drivers (housing, international economic growth, etc.). Interestingly, the sectors seem to have bifurcated during the past six months, with the industrials sector showing some of the strongest sector returns year-to-date, and the materials sector showing positive returns but lagging the overall market, primarily due to weakness in the metals and mining industry.
The two largest industries in the materials sector are chemicals (roughly 67% of the sector as of June 30, 2013), and metals and mining (approximately 17% of the sector).1 Given their large weightings, the performance of these two industries can often dominate the sector’s overall returns.
The chemicals industry returned 8.1% in the first half of the year.2 Commodity chemicals and specialty chemicals have both outperformed the sector, as chemical manufacturers have continued to benefit from abundant and inexpensive U.S. natural gas as a primary raw material. Fertilizers and agriculture chemicals, while generating positive returns, detracted from industry results, largely due to cyclical factors.
Some of the most encouraging developments are still in process. If the U.S. housing recovery continues to build as expected, makers of paint and other construction chemicals will likely benefit in the short term. Long-term tailwinds from the domestic energy industry include cheaper feedstock natural gas and increased demand for chemical catalysts. As a result, well-managed companies in this industry are likely to see even more revenue and earnings growth in the months to come.
The metals and mining industry has been the biggest drag on sector performance, declining 20.1% in the first half of 2013. With the price of gold down roughly 29% for the first half of the year, the gold sub-industry fell 40.2% in that period.3 Diversified metals and mining, a much larger component of the industry than gold, was down 15.3% year-to-date, as commodity prices quickly adjusted to a slowdown in worldwide demand, particularly from China and other emerging-market economies. However, the mining industry is accustomed to such rapid cyclical shifts, and the largest companies in the sector could benefit greatly when demand normalizes. Future economic growth in China, even if it moderates to a slower pace, will very likely still require plenty of coal and industrial metals.
Two industries within the materials sector have seen some healthy revenue growth, and have high potential for more. Construction materials have benefitted from improving pricing trends, even though the volume growth has not been as robust as anticipated while the housing recovery continues to pick up speed. Strength in residential construction is usually followed by a pickup in non-residential construction, and construction materials may then start to see greatly increased demand.
Paper and forest product companies experienced impressive revenue and earnings growth in the first half of the year, with more improvement likely to come. Year-to-date returns of 9.5% likely reflect the trend toward consolidation of the industry and recent successful price increases, both of which bode well for the future.
Valuations, which are based on the average ratio of price to estimates of forward earnings, are right around the median for the sector, reaching 14.0x in May before coming in at 13.4x for June, compared to a median of 13.9x (see the chart below).
Generally, the sector’s valuation has been gradually climbing toward the median in the first half of the year, after having not matched or exceeded the median since early 2011. With a mixed performance of the various industries, it is hard to generalize about the sector’s overall valuation. For example, interest in stocks with high dividend yields, a common theme given the current low interest rates on bonds, seems to have been a neutral factor in the sector—on a company level, investors seem to have been more interested in fundamentals. However, the current valuation for the sector suggests that there are likely many strong investment opportunities still available.
Outlook for materials stocks
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The outlook on fundamentals has many positive elements, with some short-term concerns to temper the optimism. The U.S. recovery, particularly in construction, may lend strength to the sector; if volumes increase for construction materials, the benefits of better pricing could begin to show more strongly in earnings for that industry. Inexpensive natural gas and the drive toward energy independence in the U.S. will likely be both short-term and long-term positives for the chemicals industry. Favorable changes in the paper and forest products industry will likely extend the run of that industry’s contribution to sector performance.
However, uncertain growth expectations, particularly in China and other emerging markets, may continue to weigh on certain commodity prices and especially on the metals and mining industry. In the near term, it may be prudent to focus on materials companies with strong balance sheets, capable management teams, and healthy cash flows.