Chapter 1 covered the basic categories of the Materials sector: metals, chemicals, construction materials, and paper. But that’s really an oversimplification—all the metals and chemicals have unique characteristics and drivers. This is also true of the other Materials industries and the sub-industries that comprise them.

Before making any portfolio decision, you must understand what makes each distinct sector component tick. This chapter explores the sector’s sub-industries and how an investor can form an opinion on each.

Let’s start by breaking down Materials into its different components. According to GICS, the Materials sector consists of one industry group (Materials), five industries, and 15 sub-industries. Below are Materials’ industries and corresponding sub-industries.

Metals & Mining

Chemicals

Construction Materials

Paper & Forest Products

Containers & Packaging

Sector weights show each sector’s relative importance in driving overall index performance. While Materials is the third largest weight in the MSCI Emerging Markets index, it’s the smallest weight of any sector in the US-based S&P 500. Why do Materials have more relative weight in emerging markets? Given a wealth of natural resources, but a lack of infrastructure and discretionary income to support other sectors, emerging markets typically have larger Energy and Materials sector weights than developed countries.

Since the weights are representative of the underlying sector and regions’ structures, the weights aren’t fixed and can change over time because of performance differences, additions and deletions of firms to the indexes, and a variety of other factors. For example, Financials wasn’t always the biggest in most indexes. For many decades, Industrials dominated.

Understanding how your benchmark and the sectors within it are structured is crucial to developing a portfolio, since wide deviations in weightings can exist across regions and benchmarks. For example, in some countries, Materials is by far the largest sector; while in others, it’s barely a few percent. Table 4.2 shows the Materials sector’s weight in selected countries, based on the MSCI All Country World Index. Note the stark differences between developed and emerging market countries. For example, Peru’s stock market is dominated by Materials—mainly mining firms—but the big, diverse US market is near the bottom of the list with only a 3.5 percent Materials weight.

Not only can sector weights vary, but so can industry weights—sometimes greatly, depending on the chosen benchmark. Table 4.3 shows the weight of each Materials industry within each benchmark.

Understanding these weights allows you to not only properly weight your portfolio relative to your benchmark, but also effectively utilize your time by focusing on the most important components. (And for this reason, this book focuses more on the two largest industries—Metals & Mining and Chemicals—and less on the smallest industry—Containers & Packaging.)

Metals & Mining is the largest Materials industry in most broad global and non-US benchmarks. Because the industry is concentrated in dominant foreign mining firms, it has a much smaller US weight (Chemicals hold the largest US weight). The Metals & Mining industry also has less impact on small cap indexes (like the Russell 2000) because much of its weight is concentrated in larger firms. This wasn’t always the case, but as machines have replaced manual labor and fixed costs have risen as a percentage of total costs, the benefits of economies of scale have grown and so have the firms.

It’s important to consider regional composition as well. In a top-down context, local economic and political conditions have a large impact on sector, industry, and sub-industry performance. For example, if the US outperforms, that bodes well for the Chemicals, Paper & Forest Products, and Containers & Packaging industries—all with large US weights relative to the rest of the sector. For a similar reason, if the emerging markets outperform, Metals & Mining and Construction Materials should benefit. Using the MSCI All Country World Index (ACWI), Table 4.4 shows the regional distribution of global Materials industries.

Table 4.5 further breaks down sector sub-industry weights (largest weights by index are bolded). Gold made a lot of headlines in 2007 and 2008, but note it makes up just 0.4 percent of the MSCI World Index and 6.1 percent of the MSCI World Materials sector. It’s an even smaller weight in most other benchmarks. You could ignore gold altogether and not significantly impact your ability to outperform most Materials benchmarks.

Diversified Metals & Mining has the most impact in global indexes, because it contains firms producing copper, iron ore, and coal, the three largest revenue sources for global mining companies.

Notice how the structure of industries described in Chapter 1 influences the weightings across indexes in Table 4.5. For example, Commodity Chemicals has its greatest weight in Emerging Markets and Specialty Chemicals has its greatest weight in the small cap Russell 2000 Index. Can you guess why? Because commodity chemicals are priced globally and compete fiercely on production costs, producers have migrated to regions with the lowest cost of production. By comparison, specialty chemicals are priced regionally and serve niche markets, so a host of small regional producers exist.

Table 4.6 shows the percentage the 10 largest firms make up in each Materials industry of the MSCI All Country World Index. With concentrations ranging from 45 to 85 percent of the industry, the largest firms truly dominate. A complete listing of the 10 largest firms in each Materials industry of the MSCI All Country World Index can be found in Appendix B.

It’s important to understand the structure of the largest firms in each industry to help make over- and underweight decisions within the sector, but if you don’t have the time for that, you should at least familiarize yourself with the largest firms in the sector. Based on the MSCI All Country World Index, Table 4.7 highlights the 10 largest Materials firms in the world. These 10 companies make up an impressive 30 percent of the sector’s weight in the index.

Now that you have an understanding of how the sector is structured, let’s use the questions we learned in the last chapter to briefly analyze each industry and its components.

In the following analysis, when a material is priced globally, we have also listed where you can find its future price expectations (recall from Chapter 3 it’s your forecast relative to expectations that matters). Regionally priced materials typically lack the same simplistic pricing transparency, but regional producers often release their prices and forecasts in quarterly earnings reports or presentations found on company websites.

Figure 4.1 shows only 40 of the largest firms, but still provides a good representation of what’s important overall because the industry is so concentrated. In fact, the four biggest firms represent 43 percent of the group’s revenue and 47 percent of the earnings.⁸

Copper was covered in the last chapter, so now let’s look at this industry’s other major materials and their unique attributes. They include:

All are priced (and should be evaluated) globally, with the exception of steel and coal, which have varying degrees of regional traits. Producers of these materials also have two basic business models: processors (steel and aluminum) and miners (virtually everything else).

Just a few nations are blessed with high-grade iron deposits. In 2006, Brazil, China, and Australia were responsible for about 60 percent of global production. Significant volumes are exported to meet global demand because of regional scarcity. This makes transportation infrastructure—railroads, ports, and ships—as important as mines in determining total production. Fixed costs involved in building mines and related infrastructure are enormous, creating a high barrier to entry and making economies of scale crucial. These factors also create significant pricing power and a high degree of concentration. For example, in 2006, the top three producers (Vale, BHP Billiton, & Rio Tinto) controlled roughly 35 percent of global production and 75 percent of global exports.¹² (A full breakdown of regional production and consumption can be found in the Iron Ore Minerals Yearbook, produced annually by the US Geological Survey (USGS), at http://minerals.usgs.gov/minerals/pubs/commodity/iron_ore.)

Similar to iron ore, coal is a bulk good, with over five billion metric tons of coal consumed globally each year—more than twice as much as iron ore. Therefore it has many similar characteristics, including annual pricing contracts. However, because it’s relatively abundant globally, production is fragmented by comparison, and pricing contracts are often negotiated on a regional or firm-specific basis.

Because it is abundant and relatively inefficient to ship (low value-to-weight ratio), coal is also generally consumed domestically by producing countries. For example, in 2006, only about 19 percent of global coal production was shipped overseas. Regional drivers should always be considered when evaluating coal producers.¹⁵

Note: Not all coal producers fall in the Materials sector. All of Materials’ coal exposure is from diversified miners—who are some of the world’s largest coal producers, but who also mine a variety of other metals. All pure coal producers fall within the Coal & Consumable Fuels sub-industry in the Energy sector. For more on how a pure coal producer fits within your portfolio’s Energy allocation, refer to Fisher Investments on Energy. Additional coal information can also be found at the World Coal Institute (www.worldcoal.org) and the Energy Information Administration (www.eia.doe.gov).

Because steel comes in hundreds of grades and shapes serving specific markets and has a relatively low value-to-weight ratio, steel is priced, and should be evaluated, regionally. For example, in 2007, South Korea had by far the world’s largest commercial shipbuilding industry, serving as a primary driver of the country’s steel demand. By comparison, in the US, autos and non-residential construction were the largest end markets, and shipbuilding was only a fractional percentage.

Such regional end markets also caused the steel industry to become fragmented—in 2006, the top 15 steel producers only represented about one-third of global steel production.¹⁷ Although it’s priced regionally, like with coal, significant steel trade does take place. In 2007, the US imported about 25 percent of the steel it consumed.¹⁸ As with coal, exporting steel reduces a region’s supply and drives up regional prices until a balance is reached. Therefore, regional prices generally move in the same direction as global prices. You can see regional and global prices moving in the same direction, though in different magnitudes, in Figure 4.2. The graph shows prices of one of the most common types of steel for the US, Europe, and China. In the second half of 2003, China had the group’s highest steel prices; but by the start of 2006, it had the lowest prices. Such fluctuations are due to regional events like changes in regional supply and demand, shipping rates, tariffs, and currency fluctuations.

Flat steel is flat sheets, in many different grades, and can be shaped and used for everything—from autos to ships to machines. Hot-rolled steel—poured into flat sheets—is the most common. Cold-rolled—run through rollers to increase its density and change its strength and flexibility—is of higher value.

As covered in Chapter 2, if scrap is abundant, mini-mills have a number of advantages over traditional iron ore-based producers, including lower energy and transportation costs.

Because they are priced regionally, most steel products are not exchange traded. However, in 2008 the LME began listing a few steel products for the first time. A futures curve showing price expectations for them can be found at their website (www.lme.co.uk/steel.asp). Additional steel information can be found at the International Iron & Steel Institute (www.worldsteel.org).

Gold is relatively unique among the basic materials because investors can consume it directly, whereas most basic materials are consumed almost exclusively for industrial purposes. This makes gold demand rather fickle—it can shift wildly with investor sentiment. Other precious metals like platinum and silver share this trait, but to a lesser degree. Investors typically demand gold as a store of value. When the risk of holding paper money is perceived to be increasing, gold’s attractiveness increases.

Recall Figure 2.5 showed inflation increasing in the 1970s and the subsequent run-up in gold prices. Near its peak in 1980, investor demand had risen to 35 percent of total consumption. After the stable monetary periods of the 1980s and 1990s, however, investor demand for gold declined and gold prices stagnated. By 2000, it had dropped to just 4 percent of consumption. In 2007, investor fears of the US financial system and inflation from rising raw material prices along with the introduction of gold ETFs (exchange traded funds), stoked investor demand for gold once again. Investor consumption rose to account for 19 percent of consumption in 2007, and gold prices rose once again.²¹

Figure 4.3 shows how closely demand for gold can be tied to its role as a store of value. From the start of 2007 through mid-2008, a strong negative correlation existed between the strength of the US dollar and the price of gold. As the US dollar weakened and demand for an alternative store of value increased, gold prices correspondingly rose. Don’t be fooled—the strength of this relationship can vary widely over time depending on investor sentiment, and a weak dollar is by no means a sign investors should always load up on gold.

Because gold is viewed by many as an alternate store of value, gold producers tend to have higher stock market valuations (P/Es, etc.) than most mining companies. Most metals ’ worth is defined by their usefulness since virtually all consumption of most metals is for industrial purposes. This can fluctuate significantly over time depending on the economic environment and available technology. As a store of value, however, gold’s worth is perceived (rightly or wrongly) to be more stable with fewer risks to future substitution or replacement. Therefore, producers are generally expected to generate more stable cash flows.

Another source of potential gold supply is central banks—in 2007, global central banks held roughly 30,000 tons of gold. Fortunately, central bankers understand their ability to impact the market and are usually very deliberate with their sales. (A detailed listing of central bank gold holdings can be found at the World Gold Council—www.research.gold.org/reserve_asset.)

Gold producers can also affect supply and demand in the futures market through hedging activity. Producers often sell future production for a set price today to protect against a decline in gold’s value or to help fund new projects. To eliminate or cover their positions, they must purchase gold contracts.

Aluminum starts as bauxite, one of the most common ores in the earth’s crust. Bauxite is mined, broken down in a chemical bath, and heated to create alumina, a white powder. Alumina is then dissolved into liquid form and undergoes an extremely energy-intensive process of electrolysis to create aluminum. Because aluminum processing is so costly, aluminum producers typically have higher variable costs than miners, and energy prices are extremely important in determining aluminum prices and producers’ profitability.

When energy prices are low, producers may choose to focus on expanding in areas with low construction and capital costs. When energy prices are high, however, producers typically expand in regions with a competitive advantage in energy. From 2006 through 2008, as energy prices increased to record levels—with the exception of China and its partially subsidized producers—most new aluminum production was focused on low-cost power regions, including Iceland (geothermal), Brazil (hydroelectric), Canada (hydroelectric), and the Middle East (oil and natural gas).

Aluminum’s largest end markets are transportation (airplanes and autos—more aluminum than steel is now used in autos), construction, and packaging. In 2007, these end markets combined to account for about 70 percent of aluminum’s end use. A full breakdown of the metal’s end use can be found through the LME (www.lme.co.uk/aluminium_industryusage.asp)—where you can also see future price expectations because aluminum is traded globally.

Stainless steel is the primary end market for nickel and the primary driver of consumption growth. In 2007, stainless steel accounted for about two-thirds of consumption and virtually all of the consumption growth. Stainless steel’s end markets are rather varied, with autos and construction being the largest components. Nickel is traded globally on futures exchanges, and future price expectations can be found through the LME (www.lme.co.uk/nickel.asp). Additional information on production and consumption can also be found through the LME (www.lme.co.uk/nickel_industryusage.asp) and the International Nickel Study Group (INSG, available at www.insg.org). Although some of the INSG’s data is only available for a fee, the speaker presentations are free and often provide good summaries.

With that in mind, let’s look at Chemicals’ major sub-industries more closely (Diversified Chemicals is excluded since it’s a combination of Commodity and Specialty Chemical.):

No shortage of feedstock exists to produce commodity chemicals (chemical production only makes up a small percentage of total oil and natural gas consumption), so production is constrained only by profitability. Recall from Chapter 1 that firms compete primarily on prices. Therefore, competition to lower production costs is cutthroat in the battle for market share. The lack of pricing power also makes commodity chemical production extremely cyclical and dependent on economic growth.

An example of the importance of production costs can be seen in the expansion of commodity chemical production in the Middle East following the dramatic increase in energy prices from 2003 to 2008. Higher energy prices increased production costs and forced commodity chemical prices higher. This significantly increased earnings for any firm self-sufficient in the raw material. The Middle East took advantage of its dominant position in oil and natural gas by building enough large commodity chemical processing centers to double its ethylene capacity and increase global capacity by over 25 percent from 2006 through 2011.²⁵

Only the largest commodity chemicals are exchange traded. Future prices of low density polyethylene and polypropylene (essentially ethylene and propylene) can be found through the LME (www.lme.co.uk/plastics.asp).

Equipment and technology is by far the most costly component of production (carbon fibers themselves are made from petroleum). Until very recently, production costs kept carbon fiber out of widespread commercial use, though that didn’t stop the military from developing jet fighters with it. Recent improvements in technology over the last decade, however, dramatically dropped production costs and opened a new array of uses. Today, lower-grade carbon fiber is commonly used in sports equipment, industrial applications, and turbines (propellers in wind farms). High-grade carbon fiber is used in new commercial aerospace designs (approximately 50 percent of Boeing’s new 787 plane and 25 percent of the structure of Airbus’ new A380 is made from carbon fiber).²⁶ Aerospace is the largest end market for carbon fiber—in 2006, an estimated 40 percent of total carbon fiber demand was from aerospace. A detailed breakdown of its end uses can be found through Zoltek, one of the few US-based carbon fiber producers (www.zoltek.com/carbonfiber/future.php).Carbon fiber is also being tested in cars, but is primarily used so far in Formula One race cars and other high-end applications where cost is less of a consideration. However, the higher the price of fuel, the more attractive carbon fiber becomes for autos. Should oil prices rise high enough and carbon fiber’s production costs continue to fall, you could one day drive a very light and fuel-efficient car whose structure contains virtually no metal at all.

Because of significant technological barriers, barriers to entry are high. And because of its military applications, the technology behind producing high-grade carbon fiber in particular is closely guarded by governments. This has led to a concentrated industry and high operating margins. In 2007, operating margins averaged over 20 percent and only seven major producers existed, with three of them (Toray, Teijin, and Mitsubishi Rayon—all Japan-based) controlling 70 percent of the market.²⁷ Carbon fiber is priced regionally and by its specific grade and end market. Therefore, it’s not priced on a futures exchange, and future price expectations are not easily determined. Future production and consumption forecasts, however, are obtainable through industry trade sources such as Composites World (www.compositesworld.com).

Government regulations also have significant impacts through tariffs, subsidies, and bio-fuel mandates. Driven by government mandates, US corn-based ethanol capacity doubled from 2001 to 2005 and doubled again by the end of 2008.²⁹ Production was also encouraged by a $0.51 per gallon subsidy and $0.54 per gallon tariff on otherwise cheaper sugarcane-based imports from Brazil. The growth in ethanol consumption has significantly impacted crop demand. Ethanol processing consumed 14 percent of the US corn crop in 2005 and 25 percent in 2008.³⁰

Due to increased meat consumption and growth in bio-fuels, food demand is projected to increase between 2.5 to 3.5 times by 2050 despite the population increasing by less than 50 percent.³¹ This sub-industry, however, should not be expected to provide all of the necessary growth in crop production. Better farming methods, more efficient equipment, better distribution networks, and improved technology (like refrigeration) will also increase the availability and supply of food. In 2006, poor infrastructure and a lack of refrigeration meant over 30 percent of all produce in India spoiled before reaching the consumer³²—a little technology would go a long way toward increasing food supply in many regions.

Prices are set regionally. Governments are often involved in regulating producers because there are social fears of genetically modified food in many countries. Despite the fears, emerging market countries have been quick to (rather sensibly) accept genetically modified crops because of potential yield gains. In 2007, global planting of genetically modified crops increased 12 percent, with a 21percent growth rate in emerging markets, but only a 6 percent growth rate in the developed world.³³ It is easy to see why emerging markets have embraced the technology. In 2002, India introduced genetically modified cotton capable of resisting a pesky caterpillar called the bollworm. By 2007, it had gone from being a net importer of cotton to the world’s third largest exporter, and total production roughly doubled.³⁴

Emerging markets aren’t alone in implementing the technology. The US has also generally been quick to accept it. In 2008, more than 70 percent of the US corn crop was genetically modified.³⁵ Europe has consistently been the slowest to accept such crops due to social opposition.

Nitrogen is manufactured and priced regionally. It’s processed from natural gas in manufacturing plants and commonly concentrated into ammonia or urea. Phosphate and potash, however, are mined out of the ground and shipped around the world. Following iron ore, coal, and grains, more fertilizer is shipped globally than any other dry good. While phosphate production has been relatively evenly distributed, potash (sourced from large old marine deposits) is scarce, so production is very concentrated. In 2006, about 70 percent of phosphate production came from large and diverse regions of Africa, the US, and China, while nearly 70 percent of potash production came from just a few areas in Canada, Russia, and Belarus. Many of the same constraints and barriers to entry that apply to metal miners also apply to fertilizer miners. This includes extremely capital-intensive operations and long lead times of 5 to 10 years to develop a new mine.³⁷

Industrial gas is delivered to customers in either small cylinders (packaged gases—used for retail use or expensive specialty gases that make the cost of shipping small quantities more feasible), bulk liquid tankers (merchant gases), or via direct pipelines (tonnage gases) from onsite production facilities. The products are inefficient to ship long distances so they are priced regionally. Even when compressed under pressure, it’s relatively uneconomical to ship a canister very far. The most economic means of shipping gas is to condense it to a liquid. Unfortunately for this industry, once liquefied, its gases are no longer economical to ship long distances on a value-to-weight ratio. Therefore, the industry primarily operates on a regional basis. While different gases are produced in different ways, most industrial gas is produced by using energy to separate components from air, water, or natural gas. Therefore, energy and natural gas in particular serve as the primary variable costs. Depending on the firm, transportation and fuel costs can also be important.

You can see the divergent regional trends by comparing the US to emerging markets from 2006 through 2008. A lack of new quarry approvals made construction aggregate supply limited in the US, but quarries were abundant in emerging markets, creating very different pricing trends. Prices in the US rose, despite a steep decline in sales volumes tied to the US housing downturn. Prices in many regions of emerging markets, however, were relatively stagnant or even declined, despite large increases in sales volumes tied to infrastructure build outs. The primary driver for construction materials, including concrete, cement, and construction aggregate, is construction activity. Two-thirds of total US cement consumption occurs during the summer building period of May to October.³⁹ Figure 4.4 shows total construction spending in the US relative to the performance of the Construction Materials industry. Notice how the industry grew with total construction during the housing boom, and then fell once construction declined.

Total construction is the primary driver for all products in this industry. Construction aggregate is more sensitive to non-residential construction because it’s heavily used in road building. Cement is slightly more sensitive to residential construction.

Additional information for the US market, including annual cement production and consumption on a state by state basis, can be found at the Portland Cement Association (www.cement.org/econ/index.asp).

The primary driver for lumber is residential construction—the numbers shift from year to year, but it’s not unusual for new home starts to account for up to 40 percent of US consumption.⁴⁴ Although significant overseas trade of lumber and softwood in particular is rare, the US is the largest importer of forestry products in the world. The reason is its proximity to Canada—which has about 10 percent of the world’s total forests.⁴⁵

Environmental and regulatory factors often play a large role in this industry, including the Endangered Species Act of 1973 and the Roadless Area Conservation Rule in 2001. In 1990, the Endangered Species Act protected 6.9 million acres of federal timber land in the Pacific Northwest—an area larger than the states of Massachusetts and Rhode Island combined—for the spotted owl.⁴⁶ The Roadless Area Conservation Rule of 2001 protected about a third of the national forest system’s total acreage, or 58 million acres, from roads and logging.⁴⁷

In Europe, Sweden and Finland have historically been the largest net exporters of paper and forestry products.⁴⁸ After the fall of the Soviet Union, however, Russia began to emerge as the dominant regional force—its vast natural resources and investments in the paper and sawmill industries had long been neglected under communist rule. Russia has the largest timber reserves in Europe, with an estimated one-fifth of the world’s softwood forests and has become one of the world’s largest lumber producers.