5
STAYING CURRENT
Tracking Sector Fundamentals
By now, you should have an understanding of the Materials sector’s history, structure, and drivers. But how do you keep track of the sector moving forward?
There are really only three items to track:
1. Supply
2. Demand
3. Sentiment
Higher demand for a static supply level supports higher prices and higher earnings. And regardless of earnings growth, sentiment can get overheated, causing firms to become overvalued in what can become a bubble (though actual bubbles are far rarer than most think). Or it can cause firms to become undervalued, which often happens near the bottom of a bear market and sometimes in bull market corrections. But to understand if a firm is under- or overvalued, you must understand how to track the direction of high-level drivers and fundamentals.
Using Industry Concentration to Your Advantage
You needn’ t track every Materials firm in the world to keep tabs on the factors impacting industries and sub-industries. Tracking the largest and most dominant firms often provides insight on important near-term factors impacting the entire industry (see Table 4.6 for industry concentrations). Quarterly earnings presentations (on company websites), conference calls, and analyst Q&A at the end of conference calls are often good sources (conference call transcripts can be found at http://seekingalpha.com/tag/transcripts). The 10 largest firms in each Materials industry in the MSCI All Country World Index (one of the broadest indexes) are listed in Appendix B.
WHAT TO WATCH
It’s not possible to list every potential factor affecting Materials. Instead, we’ ll focus on the most important and widely tracked fundamentals in determining supply and demand. Factors affecting globally priced materials should be tracked globally; likewise, factors affecting regionally priced goods should be tracked regionally. A list of industry data sources is also provided in Appendix A to help you perform your own research and analysis.
Fundamentals to watch include:
• Gross domestic product (GDP) growth
• Residential and non-residential construction
• Durable goods orders
• Industrial production
• Global materials production growth
• Inventories
• Global materials trade (imports and exports)
• Capacity utilization
• Raw material costs
• Marginal cost of production
• Tariffs, royalties, subsidies, and price caps
• Freight rates
Table 5.1 Bullish and Bearish Fundamentals for Prices of Basic Materials
| Bullish Drivers | Bearish Drivers |
|---|---|
| Rising GDP growth | Falling GDP growth |
| Rising non-residential construction | Falling non-residential construction |
| Rising residential construction | Falling residential construction |
| Rising durable goods orders | Falling durable goods orders |
| Rising industrial production | Falling industrial production |
| Falling global materials production | Rising global materials production |
| Falling inventories | Rising inventories |
| Rising global imports | Falling global imports (unless supply driven) |
| Rising capacity utilization | Falling capacity utilization |
| Rising raw material costs | Falling raw material costs |
| Rising marginal cost of production | Falling marginal cost of production |
| Increased commodity regulation (tariffs, etc.) | Decreased commodity regulation |
| Increased freight rates | Decreased freight rates |
Table 5.1 breaks these factors into bullish drivers—those likely to help drive the prices of basic materials higher—and bearish drivers.
GDP Growth
Global GDP growth is the most powerful Materials demand driver (covered in Chapters 1 and 3). Rising global GDP per capita signals increasing industrialization as governments invest in infrastructure, causing productivity and standards of living to increase. Industrialized societies with high GDPs per capita consume more basic materials per capita (covered in Chapter 3). It’s vital to shape an opinion on whether economic growth rates globally will be above or below expectations when making Materials sector decisions for your portfolio.
Gross domestic product (GDP) is also one of the easiest factors to track (but not necessarily to forecast, as any economist will attest). Detailed breakdowns of US GDP can be found through the US Bureau of Economic Analysis (www.bea.gov ). Breakdowns of global GDP are at the International Monetary Fund (IMF, available at www.imf.org). Both global and regional GDP are useful in tracking Materials consumption.
Figure 5.1 US Real GDP by Quarter
Source: Thomson Datastream.
Remember GDP growth is often volatile and you should focus on the overall trend rather than getting caught up with any single quarter. This can be seen in Figure 5.1, which shows US quarterly GDP growth from 2000-2007. GDP growth varies widely and rarely forms a smooth line.
There are also a few economic components within GDP that Materials analysts pay especially close attention to involving construction and industrial output.
Residential and Non-Residential Construction Residential and non-residential construction are major basic material consumers. These metrics are especially important for many regionally priced materials like steel, lumber, cement, construction aggregate, and some specialty chemicals, which are all heavily used construction materials. Less construction takes place during the winter, so it’s important to compare this metric year over year.
As outlined in Chapter 4, bar steel is particularly sensitive to non-residential construction, lumber and some specialty chemicals are sensitive to residential construction, and cement and construction aggregate are sensitive to total construction. Figure 5.2 shows US residential and non-residential construction from 1998 through 2007. Bar steel provided strong results through the end of 2007. Lumber producers suffered when residential construction declined, as did paint producers, although more modestly because of less extreme exposure to residential construction (autos and consumer goods are also large end markets). Finally, cement and construction aggregate producers suffered once total construction began declining. In the US, these figures are released monthly by the US Census Bureau (www.census.gov).
Figure 5.2 US Residential and Non-Residential Construction Spending
Source: Thomson Datastream.
Durable Goods Orders Durable goods are produced to last longer than three years—cars, airplanes, or washing machines are durable goods, but shoes and shirts are not. Durable goods often make heavy use of basic materials, especially metals and plastics.
The US durable goods orders report is released monthly by the US Census Bureau. The reports are broken down by industry. The transportation industry is often removed from the report for more consistently comparable numbers because of the volatility involved in big ticket orders like airplanes. As you review this report, keep in mind that orders can be canceled.
Industrial Production Industrial production is a measure of the total output of factories and mines and includes durable and nondurable goods. This is a more reliable measure of what is actually being produced, rather than just ordered. However, it’s also backward-looking, while the durable goods orders report is forward-looking (i.e., predictive).
This useful metric in determining trends in US Materials consumption is released monthly by the Federal Reserve Board.
Global Materials Production Growth
Global production growth in materials can dramatically impact prices by increasing supply. But for purposes of investing in stocks, it’s always production relative to expectations rather than absolute production that matters. If global production increases but remains below expectations, basic materials prices will remain higher than anticipated, which lead to higher than anticipated earnings and usually rising stock prices. Given the long lead times (typically two years or more) in constructing highly capital-intensive production facilities, new production capacity for most of the sector can be predicted well in advance. Annual production forecasts are found through most trade publications or websites. (A list of these resources can be found in Appendix A.)
Despite the transparency into future production capacity, analysts routinely struggle to predict production. This is usually due to production disruptions like strikes, infrastructure bottlenecks, equipment failures, and weather-related outages like floods and hurricanes. When a firm can no longer fulfill its contracts, it declares force majeure. This invokes a standard contract clause that eliminates its liability for delivery failures. The clause only applies to events considered outside of the firm’s control (e.g., hurricanes, floods), not negligence or malfeasance.
Inventories
Global inventory levels are looked at closely as an indicator for consumption versus production, particularly for metals and commodity chemicals. Distributor inventory levels can be tracked to provide information about trends in consumption relative to production. However, products like specialty chemicals and construction aggregate serving regional or niche end markets typically sell directly to the end user and a consolidated traceable inventory often doesn’t exist.
For goods priced globally on exchanges, analysts usually track only a few key global storage center networks. For goods priced regionally, analysis of each region’s inventory levels (if available) is necessary to determine its impact. The most commonly tracked global inventories for industrial metals are at the LME. But steel inventories are tracked regionally through steel service center inventories (steel distributor warehouses).
Figure 5.3 shows LME copper inventory levels relative to price. As inventory levels declined and consumption increased faster than production, prices generally rose. Note that inventories are not a perfect indicator predicting every price movement. Instead, they can be used as a general guide.
Figure 5.3 Copper Prices vs. Inventories
Source: Thomson Datastream.
All Inventories Are Not Created Equal
Analysts track inventories in China, but China’s inventories can mislead. The political environment is far from open, and estimating real inventory levels can be tricky. In the second half of 2006, copper prices confused many observers, causing some to predict a global economic downturn as prices fell by over 30 percent from early July through the following January. Global economic growth, however, remained strong, and copper prices eventually rebounded sharply in early 2007.
In hindsight, analysts suspect China built up inventories and stopped buying significant quantities of copper on the open market. Copper prices fell until China used its inventory and began repurchasing copper on the open market. Because of such distortions, inventories at the LME are generally considered more important. This also serves as an example why timing short-term moves can be fraught with danger.
Source: Bloomberg Finance L.P.
Global Materials Trade: Imports and Exports
Changes in imports and exports provide an indication of changes in consumption and production. Since basic materials are among the most traded goods in the world (iron ore, coal, grains, and fertilizers make up the largest volumes of dry goods shipped globally),1 tremendous trade data exists.
Fortunately, you needn’t look at every country. Just focus on the main consumers and producers. China was the primary country responsible for the increased consumption of globally priced metals from 2000 to 2007, so it was important to track its imports during that period. (We’ll explore China’s Materials demand further in Chapter 6.)
Figure 5.4 shows China’s copper imports from 2000 through 2007. China’s monthly imports more than doubled over the period. Also notice how volatile imports can be, underscoring the importance of remaining focused on long-term trends. A decrease in global imports with no change in production usually means global demand is slowing, and prices will fall. Conversely, rising global imports signal increased demand. If global production can’t keep up and inventories simultaneously decline, prices will likely rise.
Figure 5.4 China’s Copper Imports 2000-2007
Source: Thomson Datastream.
In some cases, falling global imports can be good for many producers, as long as it’s driven by a shortfall in another producer’s or region’s supply rather than reduced demand. The numbers alone won’t tell you which is happening, so if you see falling imports, you’ ll need to analyze why before determining if it’s a positive or negative for most producers. For example, in early 2008, a large snowstorm in China caused widespread power outages and led to a significant reduction in aluminum production. The decline in production caused global aluminum prices to increase, benefiting all the producers outside of China.
For products like steel and aluminum with wide varieties of shapes and qualities, it’s important to track net imports (imports minus exports) and net exports rather than just the absolute number. A country may simultaneously export and import large quantities of different grades of material, but we’ re most interested in the net effect. Exports and imports are among the most indicative reflections of global supply and demand.
Capacity Utilization
Capacity utilization indicates the percentage of a region’s or the world’s production capacity currently being used. It’s a useful proxy for measuring regional or global demand relative to the industries’ potential production capabilities. For practical reasons (including maintenance and repair), capacity utilization will almost never reach 100 percent. In fact, anything over 90 percent is generally considered a very strong number and indicative of tight supplies relative to demand.
Capacity utilization usually rises in periods of high demand as firms increase production and maximize their production. In times of low demand, some facilities may be unprofitable to run and may sit idle or temporarily close for maintenance.
Not only are changes in capacity utilization closely watched to measure demand, it’s also watched as an indicator of how quickly supply can increase. At a capacity utilization rate of 50 percent, an industry could dramatically increase production in a very short time to meet higher demand. With a capacity utilization rate of 95 percent, new production facilities are needed to meet new demand. In the Materials sector in particular (characterized by large and highly capital intensive projects) this can take years.
Figure 5.5 Capacity Utilization of US Steel, Mining, and Chemicals
Source: Thomson Datastream.
Figure 5.5 shows the capacity utilization rate of US steel, mining, and chemical industries from 1998 through 2007. Notice the utilization rate for some industries is more volatile than others because of maintenance needs and the greater ease with which production can be started and stopped. Note, too, capacity is simply an estimate made by the government and may not accurately reflect an industry’s true capacity. This is why it’s possible for capacity utilization to exceed 100 percent in some cases, as the US steel industry did in 1994 and 2004. The utilization rate is simply designed to give a rough estimate of current total capacity. The US capacity utilization figures are released monthly by the Federal Reserve.
Raw Material Costs
Raw materials affect production costs and, therefore, profitability. Higher input costs force producers to pass costs on to consumers in the form of higher prices. In fragmented industries with limited pricing power, raw materials costs can greatly influence earnings and performance. Changing input costs have the greatest affect on chemicals, steel, paper, cement, and packaging since they are manufactured from a substrate material and have higher variable costs.
When raw material costs change dramatically, performance between vertically integrated producers (who produce their own raw materials) and non-vertically integrated producers can deviate widely (as covered in Chapter 4). Vertically integrated producers typically benefit when raw material costs are rising, but trail peers when costs decline.
Marginal Cost of Production
The marginal cost of production is the cost of producing one additional unit of something. For any level of production, the price must remain above the cost of producing it, otherwise a company has no incentive to make additional products. In a perfectly competitive environment where supply can easily adjust, prices should remain at the marginal cost of production as firms increase production at any expense as long as it’s profitable.
Industries with high barriers to entry, however, may see prices significantly exceed the marginal cost of production. When prices rise, firms have an incentive to increase production, but barriers prevent immediate new production (e.g., long lead times to develop a mine). This can magnify pricing responses to changes in demand.
An industry’s cost of production can be represented by a cost curve where the average cost of every producer, country, or even individual mine is plotted. Figure 5.6 demonstrates a hypothetical example of a copper cost curve. Some producers have lower costs than others. Typically, the steeper the right end of the curve, the more constrained new production is as producers are forced into high cost production to bring additional product to the market. For our purposes the actual costs are less important than the shape of the curve. In recent years, copper’s cost curve has risen steeply at the far right, indicating producers have struggled to find new low-cost production.
Costs are often represented net of byproducts to simplify the comparison between producers. If a copper mine also produces gold, the revenue from the gold is offset against the cost of production, and a simpler calculation of its cost per pound of copper is calculated. This allows for a simple comparison across producers.
Figure 5.6 Theoretical Copper Cost Curve
If prices are at the marginal cost of production and any factor causes marginal production costs to increase while desired consumption remains the same, prices will increase to ensure the desired production is profitable. If a producer or industry segment is unaffected by the increased costs, it will see margin expansion as prices rise and its costs remain the same.
Tariffs, Royalties, Subsidies, and Price Caps
Changes in government tariffs (export and import taxes), royalties, subsidies, and price caps can dramatically impact regional and global prices. Although increased regulation is typically a negative for long-term economic growth due to the creation of irrational incentive structures, regulation can cause the prices of some goods to rise, especially in the short term. Because government intervention is not typically coordinated around the globe, it generally has greatest impact on local producers. If the country or region, however, is a large enough consumer or producer of a good, it can affect global supply and demand. Therefore, it’s especially important to track government policies of the largest basic material consumers and producers. There’s no centralized database of easily digestible information on this subject since there are thousands of countries, goods, and varying details of each regulation. But the World Trade Organization (WTO) is often a good resource. Government intervention and political sentiment is fickle and difficult to predict. In Chapter 6, we’ ll cover a number of examples on how regulations historically affect producers and industries.
Freight Rates
Freight rates are the cost of shipping goods from one region to another and significantly impact regionally priced materials. As shipping costs rise, regional price differences can be expected to increase.
Figure 5.7 Baltic Dry Index
Source: Bloomberg Finance L.P.
Figure 5.7 shows the Baltic Dry Index—a widely tracked gauge for the cost of shipping dry goods in bulk (primarily raw materials)—from 1998 through 2007. Notice near the end of 2007, the index reached record levels because of high demand and rising fuel costs. This increased regional pricing disparity of basic materials around the world. It even caused 2008 annual iron ore contracts (typically priced globally) to include regional price differences based on freight charges. Due to their proximity and therefore lower freight rates, Australian iron ore producers were able to charge China, the world’s largest iron ore consumer, a higher price than Brazilian producers.
Chapter Recap
Fundamentals change over time and no single metric is always the most important or relevant when analyzing Materials prices. The dominant themes of supply, demand, and sentiment, however, remain throughout time as driving forces, and will always be important to track. It is also important to remain focused on long-term trends and not become overly sensitive to inherent short-term fluctuations in data.
• Economic growth is one of the most important drivers for basic material demand and can be tracked through government reports.
• Construction, industrial production, and durable goods orders are all subsets of economic growth. These are intensive in their use of basic materials and therefore require close scrutiny.
• Tracking production growth helps measure and forecast supply.
• Inventory levels provide an indication of trends in production versus consumption. Rising inventories indicate supply is gaining faster than demand, and prices can be expected to weaken over time. Falling inventories imply demand is gaining faster than supply, typically causing prices to rise over time.
• Import and export data provide insight into global trade, consumption, and production. Along with inventory changes, net imports, and net exports, reports from the largest producers and consumers of basic materials are often the first indication of changing global consumption or production patterns.
• Capacity utilization provide an indication of demand. The lower the capacity utilization, the more easily production can increase to meet new demand. The higher the capacity utilization, the less available additional production will be until new production facilities can be built.
• Raw material input costs affect profitability and therefore stock prices.
• The marginal cost of production determines the minimum price level for a determined consumption level and helps forecast prices. A cost curve quantifies the effects of barriers to entry.
• Tariffs, royalties, subsidies, and price caps are all forms of government intervention. They primarily affect producers on a regional basis since governments rarely coordinate such efforts. The effects can be difficult to predict, but may have significant consequences.
• Freight rates affect regional pricing disparities. The higher the rates, the less efficient it becomes to ship materials and the greater the regional pricing variations.
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