Materials, Doom or Boom?

By: Bullish Bankers Tuesday, September 30, 2008 9:01 AM

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With the equity markets trading erratically and sustained volatility making investors reconsider their strategies its hard to determine what asset class to invest in let alone a specific sector. For those of you still bullish on commodities and looking to add a little exposure through the materials sector I will be writing a seven-part series on the strengths/weaknesses of the materials sector along with my top picks for 2009 and my top stocks to short as well. I will start off with an introduction to the Materials sector and an overview of this year’s performance thus far.

The Materials sector is directly tied to commodities prices. There is a large focus on international affairs as companies target foreign economies and operate in many industrialized nations around the world. It is comprised of companies that engage in a wide range of commodity-based production and manufacturing processes. This includes companies that manufacture chemicals, construction materials, containers and packaging, metals and mining, and forest and paper products. All of these industries are capital intensive creating large barriers to entry and prolonging supply/ demand characteristics of any given industry.

The three main determinants of success in this sector are commodity prices, economic growth, and operational efficiencies. Higher commodity prices directly affect top line growth while utilization ratios determine the profitability of the their operations which key in on areas where substantial upfront investments are necessary. Economic strength is a necessity- without economic growth their is no demand for the materials produced by these companies. When searching for a profitable investment it’s important to take a top down approach. Is there a broad demand for the material they produce? Are there alternatives that could serve as a potential substitute? Does the company have proven reserves? These are just a few factors that should be considered when analyzing basic materials companies. When looking specifically at the company, it’s important they have proven production capacity to benefit from a strong market. What is the point of growing market if they can’t take advantage of the additional demand. Return ratios are a perfect indicator of whether management is operating their capital-gorging company appropriately.

With that said it’s not hard to infer that this sector hasn’t been doing very well this year. With the current financial crisis, anemic domestic GDP growth, and slowing international growth the market fundamentals mentioned above aren’t in play. For the past twelve months the Materials sector is down 14.2%. The weakest sub-sector is not surprisingly Metals & Mining which is down over 30% , and the strongest is Chemicals which is down a mere 3.3% over the same time period. The sector peaked in late June as many commodities prices approached all-time highs including oil, wheat, and most hard metals. One other thing to note is that commodities prices peaked right at the end of the second quarter when 2H08 predictions were released. It’s pretty safe to assume that many companies will not be fetching the same price for their commodity they predicted in at the end of June.

Even though this does not bode well for Q3 ‘08 this is a fantastic time to purchase shares of industry leaders and pioneers who are currently trading at a steep discount. Right now materials companies are trading at bargain prices with a P/E of 14x and PEG 1.0 compared P/E and PEG of the market of 15.2x and 1.2 respectively. The materials sector is certainly in for a rough ride ahead as Congress continues to workout an appropriate solution for Wall Street and international nations deal with varying degrees of contagion, but on the other end of this crisis lies an array of severely undervalued companies ripe for the picking.

- Darrell Reid

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9/30/2008 11:00:45 PM Inflation, Rotation, Hard Assets: by Agcapita The equity and bond markets have benefited from a long period of low inflation, but ongoing and massive central bank liquidity injections point to a far less benign environment of elevated inflation ahead. Research by our firm, Agcapita Farmland Investment Partnership (Calgary, Canada based agriculture private equity firm – www.farmlandinvestmentpartnership.com) shows investors must be prepared to rotate into asset classes with different characteristics. During the last commodity bull market & high inflation period in the 1970’s, equities materially underperformed farmland. - Western Canadian farmland went from around $100/acre to $550/acre (550% total return and 176% in inflation adjusted terms); - Cash held in a money market account barely kept ahead of inflation (6% inflation adjusted return); and the - S&P 500 index returned less than 2% per year (a loss of almost 50% in inflation in adjusted terms) We believe the world is still in the early stages of this current commodity bull market. When agriculture commodities prices are compared against their previous inflation adjusted highs they are significantly discounted implying scope for further increases: - Corn is US$ 5/bushel currently compared to US$16/bushel in 1974, - Wheat is US$ 7/bushel currently compared to US$27/bushel in 1974 - Canadian farmland is C$ 660/acre currently compared to C$1,100/acre in 1981 Agcapita’s investment team has over 40 years private equity and fund management experience and over $1 billion in total career transactions. The team currently manages a group of private equity funds with almost CAD$ 100 million of assets under management and previously managed a group of emerging market funds with almost C$500 million in assets for one of the largest banks in Europe. The Canadian farmland investment premise is driven by several key points: - Canadian farmland is high quality: Canada is the third largest wheat exporter in the world and in aggregate one of the largest agricultural producers in the world. The three western Canadian provinces alone have approximately 135 million acres of farmland and produce approximately 20 million tons of wheat a year. - Canadian farmland is low cost: Agcapita believes Saskatchewan farmland in particular is an undervalued asset. With an average price of $390 per acre, Saskatchewan farmland is some of the least expensive in the world. The prices in Alberta are almost 3 times higher than Saskatchewan at an average of $1,100. - Canada has world class farming infrastructure: Unlike investing in farmland in emerging markets such as Argentina, Brazil or Russia, Canadian farmland is supported by first world storage, processing, and shipping infrastructure. This infrastructure is extremely costly to reproduce. - Canada has low political risk: Unlike emerging markets, Canada lacks significant political risk. Canadian farmland owners benefit from a transparent and enforceable title system with no material risk of de jure or, worse yet, de facto expropriation. See recent agriculture export tariffs in Argentina. Reply Rating: (0) (0)

The equity and bond markets have benefited from a long period of low inflation, but ongoing and massive central bank liquidity injections point to a far less benign environment of elevated inflation ahead. Research by our firm, Agcapita Farmland Investment Partnership (Calgary, Canada based agriculture private equity firm – www.farmlandinvestmentpartnership.com) shows investors must be prepared to rotate into asset classes with different characteristics. During the last commodity bull market & high inflation period in the 1970’s, equities materially underperformed farmland. - Western Canadian farmland went from around $100/acre to $550/acre (550% total return and 176% in inflation adjusted terms); - Cash held in a money market account barely kept ahead of inflation (6% inflation adjusted return); and the - S&P 500 index returned less than 2% per year (a loss of almost 50% in inflation in adjusted terms) We believe the world is still in the early stages of this current commodity bull market. When agriculture commodities prices are compared against their previous inflation adjusted highs they are significantly discounted implying scope for further increases: - Corn is US$ 5/bushel currently compared to US$16/bushel in 1974, - Wheat is US$ 7/bushel currently compared to US$27/bushel in 1974 - Canadian farmland is C$ 660/acre currently compared to C$1,100/acre in 1981 Agcapita’s investment team has over 40 years private equity and fund management experience and over $1 billion in total career transactions. The team currently manages a group of private equity funds with almost CAD$ 100 million of assets under management and previously managed a group of emerging market funds with almost C$500 million in assets for one of the largest banks in Europe. The Canadian farmland investment premise is driven by several key points: - Canadian farmland is high quality: Canada is the third largest wheat exporter in the world and in aggregate one of the largest agricultural producers in the world. The three western Canadian provinces alone have approximately 135 million acres of farmland and produce approximately 20 million tons of wheat a year. - Canadian farmland is low cost: Agcapita believes Saskatchewan farmland in particular is an undervalued asset. With an average price of $390 per acre, Saskatchewan farmland is some of the least expensive in the world. The prices in Alberta are almost 3 times higher than Saskatchewan at an average of $1,100. - Canada has world class farming infrastructure: Unlike investing in farmland in emerging markets such as Argentina, Brazil or Russia, Canadian farmland is supported by first world storage, processing, and shipping infrastructure. This infrastructure is extremely costly to reproduce. - Canada has low political risk: Unlike emerging markets, Canada lacks significant political risk. Canadian farmland owners benefit from a transparent and enforceable title system with no material risk of de jure or, worse yet, de facto expropriation. See recent agriculture export tariffs in Argentina.

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The above story is the opinion of the author only and it does not reflect iStockAnalyst opinion. Further, the author is not personally advising you regarding the suitability of the story for your investment needs. In no event iStockAnalyst will be liable for any loss or damage including without limitation, indirect or consequential loss or damage, or any loss or damage whatsoever arising from or arising out of, or in connection with the use of this information. Please consult your investment advisor before making any investment decision.

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