Materials Industry

Most of the information is extracted from “Fisher Investments on Materials”.

Overview

Materials sector is composed largely of metals, chemicals, paper, lumber, cement, “construction aggregate” and packaging. Not all commodity falls under materials. The largest commodity falls in the Energy Sector and most agricultural products are found in the Consumer Staples Sector.

Some Key Characteristics of Materials Sector are:

  • Capital Intensive
  • Hypersensitive to Economic Growth
  • Regional Pricing may varies due to shipping costs, availability, import or export taxes. Shipping costs depend on the value-to-weight ratio. Pricing is usually set by the largest producers-“price setters” and the small producers -“price takers”.
  • Usually can be classified into Upstream and Downstream

Life Cycle of Metal

  • Finding Metal and Securing Permits
  • Building a Mine (capital intensive and sometimes must built transport system)
  • Separating Metal from Rock
  • Metal Smelting (lower profit margins)
  • Metal Recycling

Life Cycle of Chemical

  • Commodity Chemicals – fierce competition, mass produced
  • Specialty Chemicals – end market usually industrial manufacturing sector
  • Chemical Recycling – plastic

Life Cycle of Concrete

  • Making Construction Aggregate – Quarried near its end market
  • Cement – Primarily manufactured regionally
  • Concrete Recycling

Life Cycle of Paper

  • Cutting Lumber
  • Processing Paper
  • Paper Recycling

History of Materials

Much of the industry was developed with the industry revolution. As economy changes, materials also evolved. During certain events, some materials cost will go much higher (e.g. metals due to wars)

Materials Sector Drivers

  • Economic Growth
  • Commodity prices
  • Commodity production growth
  • Exploration and development costs
  • Production costs
  • Share buybacks and mergers and acquisitions (M&A) activity
  • Investor sentiment (can cause bubble)
  • Taxes, Politics, and regulations

Some questions to ask when analyzing a material include:

  • Is the material priced globally or regionally?
  • What is the material used for?
  • Who are the primary consumers?
  • Where is it produced?
  • Who are the largest producers?
  • What are Production’s Primary Costs?
  • Are there significant barriers to entry?
  • What is the expected change in supply and demand?

Materials Sector Breakdown

Metals & Mining

  • Diversified Metals & Mining
  • Steel
  • Gold
  • Aluminium
  • Precious Metals & Minerals

Chemicals

  • Commodity Chemicals
  • Speciality Chemicals
  • Diversified Chemicals
  • Fertilizers & Agricultural Chemicals
  • Industrial Gases

Construction Materials

  • Construction Materials

Paper & Forest Products

  • Paper Products
  • Forest Products

Containers & Packaging

  • Paper Packaging
  • Metal & Glass Containers

Some materials and their characteristics

  • Iron ore – priced globally on annual contracts. Infrastructure as important as mines in determining production. High barriers to entry, need for economies of scale, concentrated group of producers
  • Coal – priced regionally on annual contracts with some global export. Steam coal (for energy) and metallurgical coal (for steel production) are priced differently
  • Steel – Priced regionally with key distinctions among producers: bar vs flat steel production, and scrap-based mini-mills vs traditional iron ore-based operations. Significant trade and exports for many products exist as well.
  • Gold – priced globally and often a safe haven during uncertainties. India and China have the largest consumer demand while the rest are taken up by investors. Scarcity is its primary barrier to entry.
  • Aluminum – priced globally and most energy-intensive metal. Energy costs are the primary determinant of price and returns.
  • Commodity Chemicals – priced globally with economic growth as its primary driver, and oil and natural gas as its primary input cost.
  • Specialty chemicals – most priced regionally. Economic growth and specific end markets for each segment are the drivers.
  • Fertilizers & Agricultural Chemicals – priced regionally for most. Demand for increased crop production through greater yields is the primary driver.
  • Industrial Gases – priced regionally with natural gas as a primary input cost. Economic growth, industrial manufacturing, metal and chemical production, and oil refining are primary drivers
  • Construction materials – priced regionally and dependent on regional construction. Cement is more sensitive to residential construction while construction aggregate is more sensitive to non-residential construction.
  • Paper & Forestry – priced regionally with residential construction as primary driver for lumber, while economic growth is the primary driver for paper. Environmental legislation can play a big role.
  • Packaging – defensive sector with relatively inelastic demand due to food and beverage being its largest components.

3 Items to track

  1. Supply
  2. Demand
  3. Sentiment

Fundamentals to watch

  • GDP growth
    • Residential and non-residential construction
    • Durable goods orders
    • Industrial production
  • Global materials production growth
  • Inventories
  • Global materials trade (imports and exports)
  • Capacity utilization
  • Raw material costs
  • Marginal cost of production
  • Tariffs, royalties, subsidies, and price caps
  • Freight rates

Bullish Drivers

Bearish Drivers

Rising GDP growth Falling GDP growth
Rising construction Falling construction
Rising durable goods orders Falling durable goods orders
Rising industrial production Falling industrial production
Falling global materials production Rising global materials production
Falling inventories Rising inventories
Rising global imports Falling global imports
Rising capacity utilization Falling capacity utilization
Rising raw materials costs Falling raw materials costs
Rising marginal cost of production Falling marginal cost of production
Increased commodity regulation (tariffs, royalties, subsidies, etc) Decreased commodity regulation
Increased freight rates Decreased freight rates

Important Area to look in assessing companies

  • Supply/Demand Environment
  • Revenues and Earnings Breakdown
  • Production Growth
  • Reserve Replacement (e.g. mines)
  • Hedging
  • Geographic Breakdown & Geopolitical risks
  • Production Costs
  • Vertical Integration
  • Transportation
  • Government Control
  • Legislative Risks
  • Competition and Barriers to Entry
  • Technology and Innovation
  • Brand Name
  • Regulation
  • Market Share
  • Margins
  • Cash Flow Use
  • Balance Sheet
  • Interest Rates

Strategies on Materials Investments

  1. Overweighting and underweighting materials industries or sub-industries based on your market outlook and analysis.
  2. Adding value at the security level based on specific pricing outlook. Can also employed long-short, pairing style.
  3. Adding value in a materials sector downturn. Can also short or purchase inverse ETFs if bearish on materials.
  4. Investing in commodities such as futures, ETFs.

Industry Cheat Sheet

  • Metals & Mining
    • high beta and cyclical
    • Often outperforms when raw material prices are rising due to strong economic growth
    • Sensitive to EM economic growth recently
  • Diversified Metals & Mining
    • Holds large weight in most major materials index
    • extensively capital intensive, dominated by large producers and highly cyclical
    • Benefits from strong economic growth and when GDP per capita is rising
  • Gold
    • Safe haven and outperforms in times of uncertainty
  • Aluminium
    • Similar to Diversified Metals
    • Most energy intensive metal to produce. Outperforms in strong economic growth and falling energy prices
    • Performance between producers may vary due to access to lower or higher cost energy resources
  • Steel
    • Similar to Diversified Metals but less capital intensive and reduced barriers for entry
    • Evaluated regionally. Important comparison factors: iron-ore vs scrap-based producers, bar vs flat steel producers, and vertically integrated vs non-vertically integrated
    • often underperforms miners in periods of rising raw material costs
    • Vertically integrated producers with upstream raw material operations often outperform non-vertically integrated in periods of rising raw material prices
    • fragmented sub-industry of small producers and generally small cap outperforms large cap
  • Precious Metals & Minerals
    • Similar to Gold
  • Chemicals
    • most are intermediary and broad economic growth is one key factor
    • often outperforms in periods of strong economic growth and stable or falling energy prices
    • higher variable costs and lower operating leverage than mining industry. Less cyclical
  • Commodity Chemicals
    • often outperforms in periods of strong economic growth and stable or falling energy prices
    • characterized by large, highly cyclical firms competing primarily on efficiencies and production costs. Very little pricing power
  • Speciality Chemicals
    • Evaluated regionally
    • Sensitive to economic growth
    • most resistant in economic downturns
  • Diversified Chemicals
    • Analyzed depending on conglomerates product mix
  • Fertilizers & Agricultural Chemicals
    • heavily influenced by government intervention
    • Mostly evaluated as Speciality
  • Industrial Gases
    • Evaluated regionally, benefits from economic growth, oil exploration and oil processing
  • Construction Materials
    • Sensitive to construction expenditures
    • Evaluated Regionally
    • Construction aggregate producers more sensitive to non-residential construction. Cement producers more sensitive to residential construction
    • Global production is concentrated to a small group of dominant conglomerates producing cement and construction aggregate
  • Paper & Forest products
    • Small industry dominated by paper dominants
  • Paper Products
    • End markets are primarily in developed world. Often outperforms during periods when the economic growth rate in developed world is increasing relative to the economic growth rate in emerging markets
  • Forest Products
    • Primarily driven by regional residential construction
  • Containers & Packaging
    • Defensive
    • Rising raw materials are a negative
    • Compete on operating costs and distribution networks
    • Focused on food and beverage and least cyclical
  • Metal & Glass Containers
    • defensive and similar to above packaging
  • Paper Packaging
    • defensive and similar to above packaging

Useful Links

Key Considerations when selecting an investment instrument

Your Investment Profile/Strategy

Before making any investments, be it equities or any financial products or investment instruments, you need to understand your investment profile.

  • Investment Timeframe (how long)
  • Your risk appetite
  • Your investment strategies and asset allocation plan
  • How much time you have to review your investments
  • Your investable amount
  • Your expected ROI/investment goals

Risks involved in the investment instruments

In any investment instruments, there is always risks. Even cash is not spared as there is inflation risk. Understand the risks associated with the investment before committing. Make calculated risks and optimize the Sharpe ratio.

Expected ROI in the investment instruments

What is the expected ROI from it and how what is the timeframe.

Time needed to review the investment instruments

In every investment instruments, we always need to review it periodically. Some more, some less. But one thing that is finite is our time. Invest in something that you can manage.

Manager of the investment instruments

In most investment instruments unless you personally manage it, there is always a person or organization that administers/manages it. You want to put your money to someone that you can trust. Someone that has high integrity. You rather put your money to someone with high integrity and low competence than a high competence and low integrity person. One of the most important factors that Tom Gayle uses is that he assesses the integrity of the management of the company that he is going to invest in. You also want to place your money to someone with good track record.

Commission and Management Charges of the instruments

I had invested in products that gave marginal returns but charges me with management fees. In the end, I paid more management fees and the returns were no better than bonds.

Fundamentals of the Investment Instruments

Invest in something that you know comfortably in. You must understand how does the investment product works and what are the factors that will appreciate or depreciate the value. For equities, understand how the sector works and what is the company business model and growth plan.

 

1 Perspective 1 Value 1 Mindset for Investing

Was sharing my investment knowledge to a small group of young people starting out their investing journey. And I highlighted 3 fundamentals as below:

  1. Perspective – We are not growing money but being good stewards of our finances

We need to view finance holistically. I had seen many people going into investment hoping to make their money grow. And yes we should try to maximize our capital but it’s also not just about growing money but also watching our expenses, having the right insurance to manage risks and other usages of money that contribute to one’s dreams and goals in life. Warren Buffett lives frugally and he manages his money very well. We must not forget that money is just a tool, a resource. There are other things in life and it is a tool or resource that helps us achieve our dreams.

2. Value of Contentment

This might baffle some. Shouldn’t we be ambitious and strive for more. Yes, ambition does has its place but I find that we need to be contented with what we have and made full use of it. This places us in a position of security. And in making investment decisions, we can be more sound and rational in it.

3. Learner Mindset

I had studied many investment gurus and hedge fund managers. One thing that is in common among them. They are inquisitive. They like to dig out, research on company and business fundamentals. In today’s business environment, business conditions are dynamic and with so much information out there, sometimes it is difficult to achieve a good alpha. A cutting edge will be having more information that the rest of the investors, and that needs us to be always learning how the business works and how would the business be in the future. In fact Warren Buffett spends a lot of time reading each day just to keep himself updated with what is going on around the world.

Hard lessons learnt

Recently, I just took accepted my loss and exited my position in FOSL. The loss is around 40%. From this, I learnt a few lessons.

Loss Aversion Bias

For quite a while, I was doing trade adjustments for FOSL, doing back ratio, selling naked calls, etc, hoping it would go up. When the stock went up, I had a short window to exit the position at a narrow loss but I still hold on, hoping it would turn profit or break even. This proved to be costly.

Optimism Bias

I was overly optimistic on their acquisition and thought sales would pick up. But on hindsight, it’s an ambitious plan and with other players coming into the wearables, FOSL will have a tough fight ahead. This also happens to other counters I was holding but the loss grew wider such as ANF and CXRX. I had since exited my ANF as well.

To conclude, in our investing journey need to recognise our bias and mistakes early, take the initial losses fast and move on.

 

A simple Graham checklist

Extracted from https://www.fool.com/investing/general/2009/11/27/the-redacted-ben-graham.aspx

  1. An earnings-to-price yield of twice the triple-A bond. (If the triple-A bond is yielding 5.5%, the required earnings yield is 11%, or a price/earnings multiple of 9.1 or less.)
  2. A P/E ratio down to four-tenths of the highest average P/E ratio the stock attained in the most recent five years.
  3. A dividend yield of two-thirds the triple-A bond yield (or 3.67% today).
  4. A stock price down to two-thirds of tangible book value per share.
  5. A stock price down to two-thirds of net current asset value. (Current assets less total liabilities.)
  6. Total debt less than tangible book value.
  7. Current ratio (current assets divided by current liabilities) of two or more.
  8. Total debt equal or less than twice the net quick liquidation value as defined in rule five.
  9. Earnings growth of 7% compounded over the past 10 years (or a doubling of earnings over the past 10 years).
  10. No more than two years of declining earnings of 5% or more over the past 10 years.