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Materials and Utilities Investing Themes 2008: A Tale of Two Halves - Part 4

Commodities / Metals & Mining Jan 31, 2008 - 12:59 AM GMT

By: Hans_Wagner

Commodities Best Financial Markets Analysis ArticleThe beginning of a new year is a good time to make a new assessment of the important investment drivers and themes for the year. If you want to beat the market it is important to understand what is driving the markets and where the best sectors are to find good opportunities. By identifying these factors you will have a solid framework to assess the impact market movements and news events on your investment strategy. This is the fourth of a five part series on the outlook for the 2008 markets. The first part discussed the key drivers ending with a mention of what sectors will benefit and those that will be hurt. This Part discusses the Materials and Utilities sectors. Part 2 discussed Energy and Financials, Part 3 reviewed Technology and Consumer Staples. Part 5 will address Healthcare, Industrials and Consumer Discretionary sectors. 


For those interested in making money in this market you might want to read Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance) by Vitaliy Katsenelson. The core of Katsenelson's strategy is to break down into three key pieces what you need to look at when analyzing a company: Quality, Valuation, and Growth (QVG).

The chart below from StockCharts.com shows the performance for 2007 of the nine S&P 500 sectors. What is interesting is that seven of the sectors beat the S&P 500 for the year, with Financials and Consumer Discretionary being the laggards.

Materials Investing Themes

For this sector I am focusing on the agriculture and metals segments. 

Agriculture

Agriculture has been performing well driven by the growing economic wealth in the emerging economies throughout the world. As people become better off financially they eat better, adding more meat and better foods to their diets. In generally it takes eight times the amount of grain to feed a farm animal than people eat. As a result the demand for feed grains will grow as more and more people eat better. It is estimated that China alone will have 230 million people considered middle class over the next five years. That is larger than the population of the United States. India is close behind. Other emerging economies throughout the world are experiencing similar growth driving up the demand for food products. This demand is expect to outstrip the available supply driving up prices. Also supplies of wheat are falling as various regions of the world are experiencing droughts that are lowering the number of bushels of wheat being harvested. In fact China, acknowledging global shortages, has implemented export taxes on wheat, rice and corn. The intent is to prevent grain from leaving the country.

Biofuels are also pushing up the cost of grains, especially corn. As farmers plant more acres of corn they are planting les acres of soy beans, a very important food crop. For now it looks like the demand for ethanol from corn and other grains will double by 2030 with government mandates for more biofuel use in the U.S. and Europe. One of every five bushels of corn is now used for ethanol production. 
Trading commodity futures is a risky business as the price can rise and then fall quickly without warning. There is a fund that seeks to track the price and yield performance, before fees and expenses, of the Deutsche Bank Liquid Commodity Index - Optimum Yield Agriculture Excess Return. The index is a rules-based index composed of futures contracts on some of the most liquid and widely traded agricultural commodities – corn, wheat, soy beans and sugar. This fund with the symbol DBA has performed well and offers investors a way to participate in the growth of these important commodities without having to trade in the futures markets.

If farmers are doing well, then it can be expected that they will spend money on products that help them grow and harvest their crops. In particular fertilizer is expected to be in increased demand. PotashCorp (POT) is a large Canadian based miner of potash which is used for fertilizer. RBC Capital has increased their realized potash price assumptions for POT from $275/ton to $300/ ton for 2008 and from $300/ton to $350/ton for 2009. Many analysts believe these assumptions could still be too conservative. RBC also increased their 2008 and 2009 EPS estimates for PotashCorp from $5.40 and $6.18, respectively, to $6.50 and $8.24. The Mosaic Company (MOS) is another fertilizer company that is benefiting from the demand from farmers.

Monsanto (Symbol: MON), known as the seed company, shows the corn belt revival remains in full swing. MON, which some fund managers view as more of a biotech-aggie hybrid now, said net income in its most recent quarter (ended November 30) almost tripled to $256 million and the company also raised its earnings outlook for the rest of the year. Shares of Monsanto, which more than doubled last year, rose another 8% after the report.

Metals

Metals prices have risen sharply over the past three years and remain above their long term averages. This is particularly true of the key industrial metals: copper, nickel, steel and aluminum. This rise is unprecedented as prices of these commodities have reach very high levels driven by the global economic growth lead by China and India. Many analysts expect these strong increases in demand for most metals and minerals to continue through 2008 and 2009. With low stocks and a likely continuation of supply side difficulties, most commodity prices are expected to remain well above their long run trend over the short and medium term.

However, it is unclear how much impact a recession in the United States will have on metals and minerals prices. While the United States economy is a smaller percent of the World's GDP, it still is the largest economy and it can be expected to have a reasonably large impact on the overall demand for these materials, and as a result the prices. 

Viewed from a longer run perspective recent history and the IMF's forecasts suggest that we are currently going through a period of global growth not seen since the period of fast growth and reconstruction in OECD economies following World War 2. Specifically, there has been a structural shift favoring rapid growth in developing countries with large populations such as China and India. Growth in these economies will be resource intensive as they industrialize and urbanize.

The implications for commodity markets are likely to be significant over the long run. Projections for iron ore, aluminum and copper suggest that demand could double and even triple over the next 25 years. In time production can be expected to expand to meet faster growth in demand at more sustainable prices. But that pricing environment is expected to be significantly stronger than would be implied by historical trends.

It is expected that prices of many minerals and metals will remain above trend for longer than has been the case in the past because of constraints on the speed with which production capacity can be expanded over the next few years. Also most prices are expected to assume significantly higher average levels over the very long run than has been the case historically due to structural increases in industry costs. China has earmarked $420 billion and India has allocated $500 billion-$600 billion for infrastructure development under their current five-year plans. Right now politicians are very supportive of infrastructure growth.

However over the shorter term we can expect prices to react downward to the U.S. recession which will cause the share price of the materials companies to fall as well. Although copper spot prices have been fallen driven by fears of a global slowdown, Citigroup's research found that spot prices are well above year-ago levels. In the meantime, they assert that copper futures will remain above $2.60/lb through 2012 while aluminum is in contango through 2013.

The following is from Fitch Ratings and Thomson Financial .

Fitch Ratings said its rating outlook for the mining sector in 2008 remains stable, benefiting from favourable market conditions over the past 3-4 years that have enabled most producers to significantly strengthen their financial and liquidity profiles. 

These strong financials provide more-than-ample rating headroom against an expected weakening of some commodity prices over the next 12 months and high ongoing cash outflows due to operating cost inflation, the ratings agency said. 

Demand fundamentals for most commodities in 2008 will continue to be underpinned by strong fixed-asset investment demand from China, together with the industrialisation and corresponding economic growth of Brazil, Russia and India, Fitch said. 

However, 2008 is likely to see a divergence in pricing and demand trends between different commodities, but prices will remain at historically high levels, reflecting continuing tight supply and an upward shift in industry cost bases over the past 2-3 years, Fitch said. 

The outlook is strongest for steelmaking raw materials, with year-on-year price increases of up to 50 pct possible in the forthcoming contract price negotiations due to continuing tight supply and forecast steel production growth of around 5-6 pct.

Conversely, prices for nickel, copper and zinc are likely to fall moderately over the course of 2008, Fitch said. 

Increasing aluminum supply is likely to result in a second consecutive net surplus, with an average price of around 2,400 usd per tonne compared to around 2,650 usd a tonne in 2007. 

For the first time since 2001-02, many mining companies are likely to report lower year-on-year financial performance in 2008, reflecting moderating metals prices, increasing operating costs and the weakness of the US dollar, Fitch added. – Thomson Financial

Based on this view, I expect the Materials sector to experience a fairly significant pullback in the first half of 2008, before it returns to its long term upward trend. As a result it is best to avoid the materials sector in the early part of 2008, waiting for signs the U.S. economy is going to recover in the next six months and that the global economy is still powering ahead. It will be important to pay attention to the key industrial commodities of: copper, nickel, iron ore, steel and aluminum. 
Companies such as Freeport McMoran (FCX), Southern Copper Company (PCU), Bhp Billiton Ltd (BHP), RIO Tinto (RTP and Companhia Vale (RIO) are likely to be good prospects later in 2008. Alcoa Inc (AA), Titanium Metals Corp (TIE) and Allegyeny technology (ATI) should offer good opportunities as they are important suppliers of aluminum and titanium for the aircraft industry, especially once Boeing overcomes the delays in the 787 design and delivery schedule.

Utilities Investing Themes

Utilities typically are considered a safe place to invest during times of economic slow down and recession. Their relatively secure revenue stream and normally higher dividend yield tends to protect the stock price from falling much. However the PE ratio for utilities is on the high side, due to their good performance in 2007. 

Industry Name Number of Firms Aggregate Market Cap/ Aggregate Net Income Price/Current EPS Price/Trailing EPS Price/Forward PE Expected Growth Payout Beta

Electric Util. (Central) 25 18.97 18.48 72.96 20.49 5.95% 32.61% 0.93
Electric Utility (East) 27 23.01 23.42 19.34 18.87 8.73% 32.15% 0.84
Electric Utility (West) 17 15.67 16.83 17.24 15.99 5.73% 22.84% 0.88

As a result they are will have limited potential to move up, especially in an environment where earnings of other companies might be slowing, causing other companies' stock price to fall. As long as earnings do not fall as fast as the stock price, the PE ratios of these companies will fall as well, making them more attractive than the utilities.

In addition utilities face the growing green movement that is requiring them to produce electricity from renewable sources. These sources normally cost more to produce and as a result require Federal subsidies to make them competitive. Subsidies cause economic inefficiencies as politicians prioritize which is the preferred source of power based on their ideas rather than what is most economical. Eventually this will cause the utilities to have to deal with the problem, likely causing them additional financial hardship.

Approximately 50% of the electricity in the United States is derived from coal fired power plants. These plants are major sources of CO2, a green house gas. Converting thee plants to non-emitting operation or transitioning to other sources will require a very large capital investment over many years. The return on this investment will be many years away. As a result utilities are likely to under perform the S&P 500 for quite some time. This large investment represents an opportunity for companies that provide the engineering and construction expertise. It does not represent an opportunity for the utilities themselves.

The Bottom Line : The Materials sector will experience a difficult first half of 2008 and then return to its upward path as the prospects for the U.S. economy improve. The continued growth of the emerging economies will contribute to this rather quick recovery for the sector.

Utilities face many difficult years ahead as they strive to meet the growing electricity needs of the United States and meet the green requirements. As a result they will under perform the S&P 500 for the foreseeable future.

Readers interested in learning more about Sector investing should read Sector Investing, 1996 by Sam Stovell. It discusses how to use sector rotation in your investing endeavors. An expensive book, but worthwhile for those interested in using sector rotation strategies to improve the performance of their portfolios.

Look for the next edition where I will review in more detail my prospects for the Consumer Discretionary, Industrials and Healthcare.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Hans Wagner Archive

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