9
MATERIALIZE YOUR PORTFOLIO Investing Strategies
In this chapter, we’ll discuss various Materials investment strategies, including examples of how to invest throughout a market cycle. We’ll also briefly cover investing directly in underlying commodities. The strategies include:
• Adding value at the industry and sub-industry level
• Adding value at the security level
• Adding value in a Materials sector downturn
• Investing in commodities
While the strategies presented here are by no means comprehensive, they provide a good starting point for constructing a portfolio that can increase your likelihood of outperforming a Materials benchmark. They should also help spur some investment strategy ideas of your own. After all, using this framework to discover information few others have yet to discover is what investing is all about.
STRATEGY 1: ADDING VALUE AT THE INDUSTRY AND SUB-INDUSTRY LEVEL
The first strategy is overweighting and underweighting Materials industries or sub-industries based on your market outlook and analysis (e.g., the top-down method). Within the Materials sector, each industry and sub-industry falls in and out of favor frequently—no one area outperforms consistently over the long term. Each will lead or lag depending on drivers like the direction of raw material prices, production costs, the regulatory environment, and global or regional growth in end markets.
A look at the performance of the MSCI All Country World Materials industries from 1995 to 2007 (Table 9.1) illustrates the variability of returns. Calendar year industry total returns are compared to the Materials sector total returns. Shaded regions highlight industry outperformance.
The fundamentals, themes, and drivers covered in this book can be seen throughout the time period. Notably:
1. Metals & Mining outperformed from 2003 to 2007 when the industrialization of the emerging markets accelerated, infrastructure construction surged, and global per capita GDP rapidly increased. It also was the most volatile industry.
2. Chemicals’ largest period of outperformance came during the late 1990s in a period of strong economic growth and low oil prices. It also was the least volatile industry.
3. Construction Materials produced strong returns from 2003 to 2006 when global construction surged, due to booming residential housing markets in the developed world and infrastructure build outs in the emerging markets.
4. Containers & Packaging’s strongest period of returns involved the end of the bear market of 2000 to 2002, helped by its defensive nature, with the majority of the industry servicing the relatively inelastic food and beverage markets.
Ultimately, your decision to overweight or underweight a sub-industry relative to the benchmark should jive with your high-level portfolio drivers. Based on the themes and drivers covered throughout this book, you should now have an understanding of the fundamentals driving stock market returns and the tools to track them moving forward. Note: Always remember past performance is no guarantee of future performance. No set of rules works for all time, and you should always analyze the entire situation before investing—starting with expectations of how supply and demand may shift. The past is about understanding context and precedent for investing—it’s not a road map for the future.
MSCI All Country World Materials Industry Total Returns
Source: Thomson Datastream; MSCI, Inc.1 12/31/1994-12/31/2007
How to Implement Sub-Asset Allocation Over- and Underweights
Once you’ve evaluated a sector’s fundamentals and formed opinions about expected returns, follow these two steps to implement industry or sub-industry allocation over- and underweights:
1. Determine the weight relative to your benchmark’s weight in that category. The size of your relative bet should be proportional to your conviction. When you have only mild conviction, make a modest bet against the benchmark. When you believe you have significant information others don’t have, make a bigger bet. But never make a bet so large that, if you’ re wrong, will inflict irreparable damage to your portfolio’s return versus the benchmark.
2. Determine how you plan to fill out the allocation. You have several alternatives. You might simply buy all the stocks in that category if you don’t feel you have any useful security-specific insights. You might buy some representative stocks, perhaps either the biggest or those with the highest correlation to the category. You might buy an exchange-traded fund (ETF) or mutual fund that encompasses the category. (For more information on available TFs, visit www.ishares.com, www.sectorspdr.com, or www.masterdata.com.) Or you might try to add additional value with security selection strategies.
Industry and Sub-Industry Cheat Sheet
Sectors and their components are dynamic, and fundamentals change over time. For reference, however, here’s a quick cheat sheet with pointers on each industry and sub-industry.
METALS & MINING
• The industry can be thought of as the “high beta” industry in Materials. It tends to be extremely cyclical and volatile due to its extreme levels of capital intensity and operating leverage.
• It often outperforms the rest of the sector when raw material prices are rising, due to strong economic growth and rising global GDP per capita (industrialization).
• In recent years, Metals & Mining was particularly sensitive to economic growth in the emerging markets, where most new metal consumption took place.
Diversified Metals & Mining
• Makes up a large weight in most major Materials indexes, so it’s a good idea to hold at least a small allocation of it in any Materials portfolio to reduce benchmark risk.
• This sub-industry is extremely capital intensive, tends to be dominated by large producers, is highly cyclical, and outperforms when raw materials prices are rising.
• Benefits from strong economic growth and periods of industrialization when global GDP per capita is rapidly rising.
Gold
• Often outperforms other Materials sub-industries in periods of uncertainty when investors are looking for a safe haven or are fearful of inflation.
Aluminum
• Its demand drivers are very similar to Diversified Metals & Mining.
• Because it’s the most energy-intensive metal to produce, it often outperforms in periods of strong economic growth and falling energy prices.
• Performance between producers in this sub-industry may differ significantly depending on the direction in energy prices and access to lower or higher cost energy resources.
Steel
• Steel producers benefit from many of the same factors as Diversified Metals & Mining, although the industry is less capital intensive, which reduces barriers to entry and makes supply more volatile.
• It should be evaluated regionally. Important comparison factors include: iron-ore versus scrap-based producers, bar versus flat steel producers, and vertically integrated versus non-vertically integrated production models.
• It often underperforms miners in periods of rising raw material costs, although regional exceptions are common.
• Vertically integrated producers with upstream raw material operations often outperform non-vertically integrated producers in periods of rising raw material prices. In such periods, firms with upstream iron ore operations also generally outperform firms with upstream scrap recycling operations, due to a higher fixed cost structure and greater operating leverage.
• It’s a fragmented sub-industry of small producers and therefore generally benefits when small cap outperforms relative to large cap.
Precious Metals & Minerals
• It benefits from many of the same drivers as Gold, but is a very small sub-industry. Unless you have a very strong opinion, you usually don’ t want to hold a significant weight in it due to benchmark risk.
CHEMICALS
• Most of the industry is an intermediary on the way from oil or natural gas to a finished product, and broad economic growth is the only driver big enough to move all the thousands of end products in the same direction at the same time.
• The industry often outperforms in periods of strong economic growth and stable or falling energy prices.
• The industry has higher variable costs and lower operating leverage than the mining industry (it must keep buying its raw material versus paying only once for the land). This makes Chemicals less cyclical with smaller booms and busts.
Commodity Chemicals
• Often outperforms in periods of strong economic growth and stagnant or falling oil prices.
• The sub-industry is characterized by large, highly cyclical firms competing primarily on efficiencies and production costs. Therefore, they hold very little pricing power and rely on economic growth as a driver.
Specialty Chemicals
• Must be evaluated regionally and according to specialized products created for niche markets.
• As with commodity chemicals, specialties are sensitive to economic growth and benefit from lower energy prices. With so many diverse end markets, however, you should choose your firms carefully as they may experience wide divergences in performance.
• Given the regional and niche markets, competition is generally the lightest in this industry, which helps specialty chemical firms retain some of the greatest pricing power within the industry. This makes the sub-industry among the most resistant Materials sub-industries to economic downturns.
Diversified Chemicals
• It is generally filled with larger conglomerates that either don’ t fit neatly into other chemical sub-industries or are vertically integrated with both commodity and specialty chemical arms.
• The same tips from the commodity and specialty chemical sub-industries apply. In this case you may simply need to mix your understanding of both sub-industries to determine your ultimate expectations.
Fertilizers & Agricultural Chemicals
• It is heavily influenced by government intervention. This includes tariffs, subsidies, trade restrictions, government stockpiles, and biofuel mandates. Caution should always be used when trying to predict government actions since political sentiment can be fickle.
• Most of the firms can be evaluated as specialty chemical producers. Genetically modified seed producers, however, have many traits in common with technology firms, while potash and phosphate miners have many traits in common with mining firms. Due to higher operating leverage and greater barriers to entry, fertilizer miners often outperform processors in periods of rising fertilizer prices.
Industrial Gases
• Industrial gases should be evaluated regionally. The sub-industry primarily benefits from strong economic growth and rising levels of manufacturing, oil exploration, and oil processing.
CONSTRUCTION MATERIALS
• It is extremely sensitive to total construction expenditures and often benefits during periods of rising construction growth.
• The industry should be evaluated regionally due to its extremely low value-to-weight ratio and limited ability to be profitably shipped. Construction aggregate is generally never shipped long distances, but some trade in cement does take place.
• Construction aggregate producers are more sensitive to non-residential construction, and cement producers are more sensitive to residential construction.
• Global production is concentrated in a small group of dominant conglomerates producing cement and construction aggregate. In the US, however, distinctive cement and construction aggregate firms exist.
PAPER & FOREST PRODUCTS
• A small industry, dominated by its paper component in most benchmarks. See Paper Products for primary drivers.
• Unless you have great conviction in your beliefs, it’s unlikely you’ll want to hold a significant weight due to benchmark risk.
Paper Products
• End markets are primarily in the developed world, while much of the end markets for other Materials sub-industries are in emerging markets. Therefore, it often outperforms during periods when the economic growth rate in the developed world is increasing relative to the economic growth rate in emerging markets.
Forest Products
• The sub-industry is primarily driven by regional residential construction.
CONTAINERS & PACKAGING
• Often acts defensively with primary end markets in the relatively inelastic end markets of food and beverages.
• Rising raw material prices are a negative due to primary inputs of metal, plastics, and paper.
• Firms primarily compete on operating costs and distribution networks.
• Firms focused on food and beverage end markets are typically the least cyclical, and firms focused on packaging for shipping are the most cyclical within the industry.
• Unless you have great conviction in your beliefs, it is unlikely you’ll want to hold a significant weight due to benchmark risk.
Metal & Glass Containers
• Often acts as a defensive sub-industry.
• See Containers & Packaging for drivers.
Paper Packaging
• Often acts as a defensive sub-industry.
• See Containers & Packaging for drivers.
STRATEGY 2: ADDING VALUE AT THE SECURITY LEVEL
A more advanced strategy entails investing in firms within a sub-industry based on a specific business mix. This strategy could be based on different opinions about specific basic materials, input costs, end markets, regions, or some combination of all the above. For example, if you think copper prices will rise while iron ore prices will fall in the near future, you could:
• Buy copper firms and sell short iron ore firms.
• Buy copper firms with little to no hedging relative to peers.
• Buy iron ore firms with relatively greater iron ore hedges than peers.
• Own non-vertically integrated steel firms and avoid or sell short vertically integrated firms.
• Own iron ore-based steel producers and avoid or sell short scrap-based producers.
These are just a few examples. Countless other tactics could be employed within sub-industries. As you become more familiar with specific Materials firms and their industries, you can eventually develop your own strategies. Always be vigilant for company-specific issues that could cause a stock to act differently than you would expect in the context of your broader strategy. (And be sure to revisit Chapter 8 for how to select individual stocks.)
STRATEGY 3: ADDING VALUE IN A MATERIALS SECTOR DOWNTURN
Most of this book focused on what drives the Materials sector and its industries forward. But what could cause a Materials boom to bust? No one sector or industry can outperform forever. The stock market eventually sniffs out all opportunities for excess returns and sector leadership changes. So it’s important to review all the drivers and question your high-level portfolio themes regularly.
One obvious trigger for a Materials sector downturn would be a decline in basic materials commodity prices. While there are countless reasons why this could happen, here are a few examples to consider.
Falling Demand
• Recession—regional or global; perceived or real
• Prolonged high prices
• Increased substitution
• Increased recycling
Increasing Supply
• New mines or processing plants beginning production
• Increased output from existing mines and processing plants
• New technology increasing production rates
• Increasing global inventories
• Easing geopolitical uncertainty
• Free trade policies
• Legislation
Should your analysis lead you to believe the next 12 months will be a bad time for Materials stocks—because of the reasons above or something else—then it may be appropriate to either reduce or eliminate your weight in Materials firms or adopt a defensive position in the portfolio.
How to Implement Your Strategy
If you have lower or negative expectations for the sector, you can:
• Get underweight by selling Materials stocks you already own.
• Short individual securities or Materials ETFs in an attempt to capitalize on an expected decline.
• Purchase inverse ETFs such as the UltraShort Basic Materials Proshares (ticker: SMN). These should rise in price if Materials stocks in general fall.
• Purchase put options on Materials stocks or indexes.
• Short commodities futures (see Strategy 4).
Because of the potential leverage involved, strategies involving options (which can be used either to augment an over- or underweight) and margin should only be used by sophisticated investors. Shorting is also a more sophisticated strategy. Keep in mind, significantly deviating from your benchmark involves the significant risk of missing equity-like upside should you be wrong. Significant deviations from your benchmark should only take place when you have strong convictions that you know something others do not.
STRATEGY 4: INVESTING IN COMMODITIES
One of the most direct ways to invest in basic materials is commodity speculation. Why mess with pesky stocks when you’ re most interested in price movements of the underlying materials? Investing directly in gold, copper, platinum, lumber, or numerous other basic materials is the most direct way to gain exposure to changes in their prices. Just because gold prices rise or fall doesn’t necessarily mean gold stocks will do the same. As covered in Chapter 3, though commodity prices typically have the greatest impact on Materials company earnings, factors like costs, production growth, and government regulations can cause producers’ performance to differ significantly from the underlying commodity. Commodity investing gets right to the heart of the matter.
But caution: Directly buying commodities is a very different process than buying stocks. It involves different tools and analyses not covered in this book. Commodity investing is also not for everyone. Commodity prices can be extremely volatile, moving rapidly on unpredictable events. Significant leverage is also commonly used in commodity investing. Fortunes have been made and lost in mere days by speculating on commodities. Investors planning to invest in commodities should be prepared to stomach extreme volatility and have high risk tolerance. That’s the dark side of commodity investing.
Commodities can also be used as a hedge. If you expect commodities to decline significantly in the short- to medium-term but still want to hold your material stocks for the long-term, you could short commodities in the futures market or use options to bet against prices. This too entails higher risk if not structured properly and should only be attempted by sophisticated investors.
How to Implement Your Strategy
The most direct way to invest directly in commodities is to call your custodian or broker and set up a futures account, which allows you to invest directly in commodity futures. There are also several ways to buy securities tied to the price of some basic materials without a futures account through other investment vehicles like ETFs or mutual funds. Table 9.2 outlines a variety of ETFs and ETNs (exchange-traded notes) designed to track commodity prices. Note: These are just a few examples of securities linked to the price of basic materials. Further research should be done for more investment options through sites such as www.ishares.com, www.sectorspdr.com, and www.masterdata.com.
Table 9.2 Commodity Tracking ETFs and ETNs
| Name | Ticker | Commodity |
|---|---|---|
| Ishares COMEX Gold Trust | IAU | Gold |
| SPDR Gold Trust | GLD | Gold |
| Ishares Silver Trust | SLV | Silver |
| IPath AIG Industrial Metal ETN | JJM | Industrial Metals |
| PowerShares DB Base Metals Fund | DBB | Base Metals (Non-Iron Industrial Metals) |
| IPath AIG Copper ETN | JJC | Copper |
| IPath AIG Nickel ETN | JJN | Nickel |
| DB Gold Short ETN | DGZ | Inverse Gold |
| DB Double Short Gold ETN | DZZ | Double Inverse Gold |
Because commodity investing is not the focus of this book, we won’t go into further detail, but there are many publications available for more information about investing directly in commodities.
We’ve covered a lot in these pages—Materials’ basics, drivers, and commonly watched industry fundamentals. But remember—like all sectors, Materials is dynamic. The drivers and fundamentals vital today may not be tomorrow. But with the top-down method, you can apply a consistent framework to analyze the sector regardless of the current environment.
Chapter Recap
We couldn’ t possibly list every investment strategy out there for this dynamic sector. Different strategies will work best at different times. Some will become obsolete. New ones will be discovered. Whatever strategies you choose, always know you could be wrong! Decisions to significantly overweight or underweight a sub-industry relative to the benchmark, using shorting or options strategies, or speculating on commodity prices should be based on a multitude of factors, including an assessment of risk. The point of benchmarking is to properly diversify, so make sure you always have counterstrategies built into your portfolio.
• There are numerous ways to invest in the Materials sector. These include investing directly in commodities, utilizing indexes or mutual funds, or buying the stocks themselves.
• Investors can enhance returns by overweighting and underweighting Materials sub-industries based on a variety of high-level drivers. For example, Diversified Metals & Mining tends to outperform Chemicals during periods of rising raw material prices.
• An advanced strategy involves making bets on firms with different business lines within sub-industries, like buying a Diversified Metals & Mining company that produces copper and shorting another that produces steel.
• Trading the commodities directly offers the best way to speculate directly on the movement of raw material prices. However, commodities can be highly volatile, and analysis involves different tools and strategies than those required for stocks.
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