Market decline

Market decline leaves some basic materials stocks undervalued

The Morningstar U.S. Basic Materials Sector Index outperformed the broader market in the first quarter of 2022 by around 500 basis points. The index was flat during the quarter, while the US market index fell almost 5%. Over a rolling 12-month period, the basic materials sector outperformed the market by 500 basis points. Due to the market decline, we see opportunities across the sector, with a third of the stock trading in 4-star territory. However, no business in 5 star territory.

Chart 1: US Commodities Index versus US Stock Index.


-source: Morningstar

Figure 2: A third of our commodity names are trading in 4-star territory.


-source: Morningstar

Freshwater costs will continue to rise as demand outstrips the readily available supply from shallow groundwater. As a result, water must come from deeper aquifers which require more expensive pumping. This is expected to drive demand for water management systems, especially in water-intensive manufacturing operations, such as food and beverage, paper and steel production.

Exhibit 3: Freshwater costs will increase as demand growth requires more pumping.


-source: Morningstar

Sales of electric vehicles will increase. Just under 5 million EVs were sold in 2021, but we expect over 32 million by 2030. Lithium is one of the best ways to invest in increasing EV sales because all EVs require batteries and all EV batteries require lithium as energy storage. making up. Therefore, as the demand for lithium increases, a higher cost supply will have to be put in place, which will increase the marginal cost of production. While lithium carbonate prices are currently high due to insufficient supply, we expect them to settle at $12,000 per metric ton, which should allow low-cost producers to generate excess returns.

Exhibit 4: We expect over 32 million electric vehicles sold by 2030.


-source: Morningstar

We foresee long-term growth for specialty chemical producers that sell to electronics and electric vehicle end markets. “Internet of Things” and 5G technologies and electric vehicles require more advanced semiconductors and electronic components. This allows specialty chemical producers to sell more content per device or vehicle, driving revenue growth at a mid to high single-digit annual rate.

Top picks

Du Pont (DD)
Number of stars: ★★★★
Economic Moat Rating: Narrow
Fair value estimate: $99
Fair value uncertainty: medium

Our top choice to play on the growth in demand for specialty chemicals is DuPont. The stock is trading at a discount of over 20% to our fair value estimate of $99. DuPont has invested heavily in its electronics business. The company acquired Laird Performance Materials in July and expects to complete its proposed acquisition of Rogers later this year. DuPont also plans to sell most of its mobility and materials portfolio to Celanese in a deal expected to close by the end of the year. This should allow the electronics end market to generate most of the profits in the future. In its historic water and protection business, DuPont should also benefit from the growth in housing starts in the United States. We view the current share price as an attractive entry point for the producer of quality specialty chemicals.

Lithium Americas (LAKE)
Number of stars: ★★★★
Economic moat rating: None
Estimated fair value: $45
Fair value uncertainty: very high

Lithium Americas is our first choice to meet the growing demand for lithium resulting from the increased adoption of electric vehicles. The stock is trading at a discount of over 30% to our fair value estimate of $45 (CAD 57). Lithium Americas does not currently produce lithium but is developing three lithium resources that are expected to come into production by the end of the decade, with the first resource going into production later this year. Once all projects are fully launched, we expect the company to become one of the top five global producers by capacity. We reiterate our very high uncertainty rating. However, for investors who can tolerate volatility, we view the current stock price as an attractive entry point.

Ecolab (ECL)
Number of stars: ★★★★
Economic fluke rating: large
Estimated fair value: $215
Fair value uncertainty: medium

Ecolab is our top pick to play on rising freshwater costs as the company’s industrial business is expected to see growing demand for its water management systems. The stock is trading at about a 20% discount to our fair value estimate of $215. Ecolab’s institutional business, which sells cleaning and sanitizing products primarily to restaurants and hotels, is expected to continue to recover from the COVID-19-related downturn as its hospitality customers benefit from the recovery by consumers of pre-pandemic activities such as dining out and travel.