Even as the broader market has rebounded from its October slump, a few sectors remain in correction territory, and value plays have emerged from the summer’s frothy market.
Shares of companies in the materials sector have plunged 13.1% so far this year, the worst performance among the 11 sectors. Within materials, chemicals have underperformed on geopolitical and macroeconomic worries but these products are the building blocks of the economy.
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There are already signs of a rebound with 3Q earnings from chemicals producers one of the few bright spots this season.
While geopolitical worries may drag for a few more quarters, this could be the contrarian play of the year and the best time to position in these value plays could be now.
Why Basic Materials Are Taking A Beating
In looking for a culprit in the selloff of shares in basic materials, you don’t need to look far.
Weak demand from China has been one of the prime selling points. Dual factors of the trade war with the United States and a program by the Chinese government to reduce domestic debt have driven GDP growth to just 6.5% on an annualized basis, the lowest growth since 2009.
Another weight on the sector has been the strengthening dollar which reached a 15-month high in October. With a large percentage of sales overseas, materials makers are hit in two ways when the dollar surges. Exports from the U.S. to other countries become more expensive, and therefore less competitive, and any sales booked overseas are worth less when converted into dollars on financial statements.
The broader materials sector is now trading for just 13.3 times expected earnings over the next four quarters versus a 10-year average of 15.2 times forward earnings. That discount of 12.5% to the long-term price multiple is the second highest among the sectors, only lower than the 29% discount in energy and compared to a 6.9% premium investors are paying for the S&P 500 versus its long-term multiple.
But shares may not stay in value territory for long.
The Chinese government has already signaled greater stimulus at a recent meeting of the Politburo. The government has announced guidance on boosting infrastructure investment as well as tax deductions for households and measures to support exporters affected by the trade war.
Things may brighten, or at least stabilize, on the dollar-front as well. A booming U.S. deficit may help to limit the attractiveness of the greenback and central bankers in Europe and Japan could start raising rates in 2019.
Three Of My Favorite Value Plays In Chemicals
The overall sector may already be signaling a turnaround with materials reporting the fourth-highest earnings growth at 25.7% in the 3rd quarter of the companies reporting through October.
Companies in the chemicals sub-group have reported a 19% year-over-year increase in earnings. I like the chemicals segment because companies in the group generally benefit from a wide range of products used across a diverse base of industries. This gives companies relative safety against any industry-specific weakness.
DowDuPont Inc (NYSE: DWDP) has announced the senior leadership that will take over each new enterprise when it breaks into three companies early next year and is estimating combined cost savings of up to $1 billion from the spinoff. Investors will get shares in each of the new companies; Corteva Agriscience, DuPont (specialty chemicals), and Dow (materials sciences).
While the split will create less-diversified companies, each will still be a leader in its segment and benefit from a more streamlined model. Estimated sales for each range from $14 billion at the agriculture segment to $40 billion at the materials segment, so these still won’t be small companies.
Shares of DowDuPont are 24% off their 52-week high reached late January and this could be an opportunity to position in three solid long-term stocks. Until the spinoff completes, the shares pay a 2.8% yield and trade for just 14.4 times trailing earnings which (cumulatively) are expected 12.9% higher over the next four quarters.
Westlake Chemical Corp (NYSE: WLK) is a vertically-integrated specialty chemicals, vinyls and polymers producer trading 40% off its 52-week high reached in May. The company has been especially hard-hit on tariff fears and that China may limit some imports.
Westlake has used an acquisition strategy for global growth but has a surprisingly strong balance sheet with debt-to-capitalization under the industry average. Balance sheet cash of $482 million offsets some of the $2.7 billion in long-term debt and annual free cash flow of nearly $1 billion.
The company has two chemical sites and a manufacturing plant in Asia to benefit from higher regional growth as well as global distribution capabilities from six European sites and more than 30 in the United States. Westlake is a leader in some of the most widely-used chemicals in the world and should have no problem surviving and even thriving despite recent geo-political worries.
Shares trade for just 9.8-times trailing earnings which are expected 5.8% higher over the next year, and pay a 1.4% dividend yield.
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Eastman Chemical (NYSE: EMN) has grown from producing chemicals exclusively for Eastman Kodak to a global leader in chemicals, plastics and fibers. The company has production in seven countries and books the majority of sales outside the United States.
Specialty chemicals under patent protection make up nearly half the company’s specialty products segment and have an average patent-life of 10 years. That gives the company strong pricing power and more certain revenue to continue R&D spending and acquisitions to retain its leadership.
Management estimates $3.5 billion in free cash flow over the next three years which should allow for healthy cash return to investors. Shares pay a 2.9% dividend yield and the company returned $350 million, 3% of market capitalization, to investors last year.
Shares are 27% off their 52-week high reached in March and trade for 9.7 times trailing earnings which are expected 6.6% higher over the next year.
Risks To Consider: Chemical makers are highly cyclical and could face further weakness if stimulus measures in China fail or the global economy stumbles.
Action To Take: Take advantage of a value discount in best-of-breed chemicals companies on the potential for an earnings rebound over the next year.