At the end of the second quarter, we wrote that we were looking forward to more buying opportunities in basic materials, as we expected profit warnings and earnings disappointments on a host of issues. We have been surprised with how quickly and severely equity markets have dimmed their view of basic materials companies. In some cases we have trimmed our fair value estimates, but in many others we've kept our long-term forecasts intact.
Given macroeconomic uncertainty, the ride is likely to be bumpy for basic materials investors. However, we attempt to value our companies based on long-term earnings expectations reflecting normalized prices, demand, and costs. As such, most of our valuations didn't keep pace with the equity market rally that led into the beginning of 2011. But now that the market's expectations have weakened, we find ourselves with a much more attractively valued basic materials universe than we've seen in several years.
Industry-Level Insights
Agriculture
Agricultural markets remained strong in the second quarter of 2011. Historically tight supplies have kept crop prices elevated, lending demand and pricing support to crop inputs, especially fertilizers. Potash Corporation of Saskatchewan, Mosaic, Agrium, and CF Industries all posted stellar results in the most recent quarter, as farmers used more fertilizer to boost yields and accepted higher prices upon the backdrop of excellent farmer economics. We think these dynamics will persist over the near term, as both fertilizer and crop supplies are expected to remain tight.
Chemicals
In the third quarter of 2011, we think the performance of the chemicals industry will likely waiver from the stronger first half, particularly as most end markets are facing sluggish demand. Despite low inventory levels, this could translate into weak demand for chemicals in the latter part of 2011. Furthermore, price increases enacted in the second quarter are likely taking full effect in the third quarter, expanding commodity chemicals margins beyond what we saw in the first half of the year.
Downstream chemicals companies will have varying degrees of success in the back half of 2011, depending on end-market exposure. The automotive end markets have been the bright spot for the chemicals industry, particularly after automakers restarted production following the broad disruptions caused by the March earthquake in Japan. However, a stubbornly high unemployment rate in the United States and a heightened sense of economic uncertainty in Europe are troubling indicators, which might potentially delay or reduce new car demand and hurt chemicals suppliers feeding into a weaker vehicle-construction season in the third quarter.
Coal
We think the coal sector stands at a critical inflection point. The tremors coming out of Europe and the slowing U.S. economy have certainly played their part in pushing down equity valuations, but the real battle will be fought in China. We have mixed data on that front. On one hand, steel production has continued to be quite strong, and the economy is expanding. However, we have abundant anecdotal evidence that government efforts to curb real estate speculation and tamp down inflation are having some effect.
Metals and Mining
Mounting signs of weakness in the Organization for Economic Co-operation and Development economies seem likely to weigh on metals demand and prices in the near term, putting the onus on China and other emerging economies to support the global demand picture. Judging by the August read of China's fixed asset investment (25.0%-plus year to date, nominal terms) and industrial value-added (14.2%-plus), the drivers of Chinese metals demand remain strong at the moment, which should provide near-term support for metals prices. That said, we have significant doubts about the economy's ability to sustain such heady fixed-asset-investment growth rates for much longer without risking a sharp and wrenching rebalancing of the economy.
With energy and carbon prices continuing to rise, and easy financing making warehousing an attractive avenue to absorb new production, we think aluminum prices will find support even as the market faces the uncertain macro environment.
Steel
The trends in steel fundamentals this year are eerily similar to one year ago but with one key difference: They're much better this time around.
Steel prices sagged in the early summer months but have since staged a rebound, and most end markets outside of the construction sector have shown continued demand improvement. Although raw-materials prices remain high, they have been far less volatile, which supports stability in inventories as well as order rates. Global economic fears make the outlook for steel demand uncertain. We think the actual sector fundamentals are much stronger now than they were two to three years ago. We believe there is plenty of room for valuations to improve barring a dramatic decline in order rates in the coming months.
Elizabeth Collins, CFA, is an associate director of equity research with Morningstar.
