Sector Overview: Basic Materials

If you are looking to invest in a miner, coal producer or chemical business, be sure you review these key investment considerations

Elizabeth Collins, CFA 6 March, 2013 | 6:00AM

Take a glance at the periodic table of elements and you will get a quick sense for the products that basic materials companies sell. If a company doesn't produce one of the elements listed, chances are it is manufacturing a compound or alloy from a combination of various elements. Basic materials companies are, by definition, commodity producers. Examples include miners such as BHP Billiton (BLT) and Rio Tinto (RIO).

Basic materials companies have been riding a wave of robust demand for commodities from developing countries

(Of course, we can name a few exceptions that are included in this sector, like seeds and specialty chemicals.)

Industries within this broad sector include: gold, silver, chemicals, steel, copper, aluminium and paper products.

Competitive Dynamies in the Basic Materials Sector

In general, this sector is defined by customers' decisions to buy primarily based on price. Since commodity producers all essentially supply non-differentiated products, customers look for the best deal and the lowest price. This means that basic materials producers are largely 'price takers', which means they must accept prices that are set in the market, except in the rare instances when oligopoly-like market conditions exist. As such, commodity prices, driven by the intersection of supply and demand, are a key determinant of these companies' earnings.

For the most part, basic materials companies have been riding a wave of robust demand for commodities from developing countries. Important exceptions include North American and European producers of building materials, which have been facing a multi-year downturn in construction activity, and paper producers in the same areas, which have been facing declining demand driven by the rise of electronic media.

Industry supply and capacity utilisation are also critical drivers of commodity prices. In some cases, a relative scarcity of economically viable mineral deposits can create a tight supply and demand balance that is likely to persist for years. In other cases, low barriers to entry enable production facilities to be added easily, and overcapacity can be the bane of industry profitability. Transportation costs are an important consideration when determining whether overcapacity in one region will bleed into another.

Given these dynamics, competitive advantages in the basic materials sector are based largely on low-cost production. Ownership of world-class mineral deposits, access to low-cost feedstocks, or highly efficient production methods are the most common ingredients. Alas, many of these advantages can eventually be replicated by competitors so relatively few companies in the basic materials space have  economic moats (aka sustainable competitive advantages).

Basic materials markets are deeply cyclical. In boom times, producers mint money (literally, in some cases). In downturns, many players can go bankrupt. All feel the pain of bear markets, but high-cost producers and those with high fixed cost structures are the most likely to feel serious pain when times are bad. An eye toward macroeconomic conditions is necessary when investing in this space.

Key Investment Considerations

Strong demand for commodities from developing countries has been critical to most basic materials companies' earnings in recent years. Any significant weakening in demand, particularly from China, could spell disaster for many producers' earnings and valuations.

Basic materials markets are highly cyclical, so be skeptical of acquisitions. Dig into commodity price assumptions and valuation multiples when deals are announced to help determine whether a company is creating or destroying value for shareholders. Scenario analysis plays an important role.

Energy costs are a key driver of earnings for aluminum smelters, petrochemicals manufacturers, and to a lesser extent cement producers. Look for companies with access to low-cost natural gas or cheap electricity. Companies with higher cost structures will have greater leverage to industry booms and busts.

Government action can impact the outlook for many basic materials companies. Legislation can help boost or destroy demand for certain commodities (think ethanol, infrastructure, and coal). However, regulation also can affect industry cost structures (mining permits, royalties, subsidies).

Basic materials industries are often capital-intensive. Watch for companies that chase high profit margins at the expense of heavy capital investment. Backward integration into feedstocks, investment in plant efficiency, and acquisition of mineral deposits can all make strategic sense, but capital costs must be weighed against potential future earnings to determine whether these actions make economic sense.

Investors in basic materials companies should know that operational problems are probable and can impact future earnings potential. Explosions, labour disruptions, geological failures, the release of hazardous materials, and natural disasters are all events that can create financial hardships.

Exchange rates also matter. Most commodities are denominated in US dollars, while many producers' costs are incurred in Australia, Brazil, South Africa, and elsewhere. A weak dollar (coupled with weak natural gas prices) can create opportunities for North American chemical manufacturers. But strengthening foreign currencies can increase the cost structures of commodity producers operating in those countries. 

Different industry sectors each display some key characteristics that may either attract or repel equity investors. Learn more about the other sectors by reading the article: "Investing in Different Industry Sectors".

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
BHP Billiton PLC2,037.00 GBX0.34
Rio Tinto PLC4,868.50 GBX0.38

About Author

Elizabeth Collins, CFA  is an associate director of equity research with Morningstar.

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