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Supplying both finished products and the raw materials used as inputs in manufacturing processes worldwide, the global materials sector feeds global supply chains. Most businesses in this sector are cyclical due to their sensitivity to changes in economic growth. Some companies within the sector are less sensitive to the economic cycle than others, such as companies that provide industrial gases to the healthcare sector. Another more defensive segment of the materials sector is the container and packaging industry, which manufactures packaging and cans for both the beverage and packaged food industries. End-user demand for certain industrial gases, packaging, and containers is relatively consistent when compared to many other goods produced by companies in the materials sector. It is important to note the operations of some companies within the materials sector are heavily influenced by events taking place in other industries. Paint and lumber producers, for example, are largely dependent on the strength of the housing market. Since the housing market is tied to changes in mortgage rates (which are derived from interest rates), changes in interest rates could eventually flow through to affect businesses in the materials sector as well. Some companies within the sector benefit from rising commodity prices and therefore perform well during inflationary periods. Operational scale is important for most of the businesses in this sector, since there is little differentiation between products and there are generally large, fixed costs associated with extracting and processing raw materials. Both product scarcity and transportation costs play a key role in determining industry dynamics, including barriers to entry, degree of competition, and pricing power.

Companies in this sector have generated strong sales and profit growth compared to the market in recent years. Additionally, they have strong balance sheets and have grown their dividends at an above-average rate. Despite this valuations for the sector have been lower than the market.

Companies within the materials sector tend to outperform immediately following bear market bottoms and in the late stage of the bull market cycle as prices start to rise and demand for base materials is strongest. On the other hand, materials companies tend to underperform the market during bear markets and in the mid-cycle portion of bull markets.

In this chapter we take a close look at the seven main industry groups within the sector: (1) agricultural products, (2) chemicals, (3) construction materials, (4) containers and packaging, (5) industrial metals, (6) mining, and (7) paper and forest products.

Agricultural Products

The agricultural industry represents approximately 4% of world GDP.¹ The companies in this industry provide farmers with everything they need to feed the world, including farm equipment and machinery, fertilizers, and food processing. The businesses listed here can be split into three distinct groups, namely food processing, farm products (seed and fertilizer), and farm equipment. While they are all tied to the agricultural cycle, these three segments differ substantially. Farm product companies produce large volumes of relatively inexpensive goods that are purchased by farmers on a regular basis, while farm equipment manufacturers produce fewer units of high-priced products, which are purchased infrequently. Fertilizer producers are dependent on feedstock (natural gas) in their manufacturing process, while farming equipment manufacturers require steel and electronic components (among other items) as inputs in manufacturing. In addition to food for human consumption, many food processing companies produce animal feed as well as nonedible products such as biodiesel and ethanol. Advancements in machinery, fertilizers, and farming techniques, along with the consolidation of agricultural land, have led to significant improvements in farming productivity. These productivity gains are necessary if we are to feed the world's population while limiting the amount of farmland created through deforestation. The global positioning system (GPS) has also dramatically impacted farming productivity. GPS and data collection sensors on farming equipment enable farmers to work in poor visibility and apply fertilizers and pesticides more selectively, reducing expenses and improving crop yields. Emerging industry trends include the proliferation of precision agriculture technology, a shift to zero emission vehicles (electrification), and the production of more environmentally friendly ammonia-based fertilizers. Economic factors that have the greatest impact on the industry include labor costs, population growth, and income growth. Important industry metrics that investors should monitor include dealer inventory levels, commodity input prices (steel, copper, ilmenite/rutile ore, chlorine, sulfur, and natural gas), freight costs, interest rates (financing costs), and operating and profit margins. Other key metrics include realized product pricing, cost of goods sold per tonne, sales volumes, and utilization rates (both for individual companies and the industry as a whole). Cost competitiveness for fertilizer producers is dependent on availability of feedstock (such as natural gas used to produce nitrogen). Standard valuation measures such as P/E, P/CF, and EV/EBITDA are commonly used to compare valuations between companies in this industry.

Chemicals

The chemical industry produces a wide range of products, including plastics, paint and other coatings, batteries, glue, solvents and cleaners, food additives, inputs for personal care products (like cosmetics and shampoo), refinery additives, as well as gases used in industrial processes and healthcare settings. According to the United Nations Conference on Trade (UNCTAD), chemicals were the most widely traded good globally in 2020, representing more than US$2 trillion in value.² The continuing struggle to reduce carbon emissions is impacting businesses in the industry as they strive to produce goods with smaller carbon footprints. Economic factors that have the greatest impact on sales growth and profitability of the industry include industrial demand and capacity utilization, interest rates, and GDP growth, as well as any factors that impact the end markets of these businesses. Companies that produce industrial gases, paint, and cleaning and solvent manufacturers are more defensive in nature and generate relatively consistent earnings throughout the economic cycle, whereas companies that manufacture base and specialty chemicals are more sensitive to economic conditions and have greater variability in earnings. Important metrics for investors to track include realized pricing, cost of goods sold per tonne, sales volumes, utilization rates, commodity prices (such as natural gas and chlorine), as well as EBITDA, and EBITDA margins by product type or segment. Each firm's relative position on the cost curve depends on the availability of feedstock in the regions in which they operate. For example, plastic producers that have easy access to an inexpensive supply of natural gas are lower on the cost curve than others that rely on natural gas imports or shipments. Standard valuation measures such as P/E, EV/DACF, and EV/EBITDA can be used to compare valuations between companies in this industry.

Construction Materials

The construction materials industry produces many of the materials needed to build large-scale infrastructure projects, such as roads, tunnels, and bridges. This includes cement (the second most widely used material in the world after water), resins, sealants and adhesives, mortar, aggregates, and asphalt. Note that although steel is used extensively in construction, it has been included in the industrial metal industry. To the extent that large infrastructure projects are financed, changes in interest rates are important to consider. Keep in mind that large projects are usually planned and funded well in advance of construction, and once started they are likely to be completed regardless of economic conditions. Emerging themes affecting the construction materials industry include decarbonization of cement as well as planned upgrades to infrastructure in many countries around the globe. Economic factors that have the greatest impact on sales growth and profitability for the industry include interest rates, GDP growth, building construction, and government spending on infrastructure. These businesses have generated above-average growth in sales, earnings, and dividends in the past few years compared to the market. Important metrics for the industry include inventories, realized pricing, cost of goods sold per tonne, sales volumes, utilization rates, commodity prices (such as cement), fuel and freight costs, leverage (net debt to EBITDA), operating cash flow, free cash flow (FCF) to net income, as well as EBITDA and EBITDA margins in each region or business segment. Standard valuation measures such as P/E, P/CF, and EV/EBITDA are commonly used to compare valuations between companies in this industry.

Containers and Packaging

The containers and packaging industry manufactures beverage cans and bottles, packaging materials for food and personal care products, as well as containerboard materials used to create boxes used to ship goods. A firm's relative position on the cost curve depends on the availability of feedstock in the regions in which they operate. For example, containerboard producers that have easy access to a supply of timber are lower on the cost curve (more cost competitive) than others that rely on pulp or paper imports or shipments. Packaging companies tend to have good pricing power and can pass through inflationary costs to customers, in part due to the relatively low cost of packaging compared to the total cost of the good being produced. ESG concerns continue to affect the packaging industry, with an increasing focus on recycling and reducing carbon emissions. Economic factors that have the greatest impact on sales growth and profitability for the industry include interest rates, GDP growth, population growth, commodity costs and availability, and shipping volumes. Despite having generated below-average growth in sales over the past few years, these businesses have grown profits and dividends at a higher rate than the market. Important metrics for companies in this industry include realized pricing, cost of goods sold per tonne, sales volume by product or segment, capacity utilization rates, cost of goods sold, commodity prices (aluminum, natural gas, polypropylene, polyethylene resin, kraft paper, and pulp), capital expenditure budgets, capacity additions, and EBITDA margin. P/E, P/CF, and EV/EBITDA can be used to compare valuations between companies in this industry.

Industrial Metals

The industrial metals industry processes raw materials to produce steel, aluminum, and other metals used to manufacture a vast array of machinery and durable goods. Similar to other businesses within the materials sector, each company's relative position on the cost curve depends on the availability of feedstock in the regions in which they operate. For example, steel producers that have access to an inexpensive supply of iron ore are lower on the cost curve than others that rely on imports for which they must absorb costly shipping fees. Economic factors that have the largest impact on industry earnings and sales include GDP growth, industrial production and utilization rates, freight costs, industrial and agricultural machinery demand, heavy equipment demand, demand for durable goods (i.e., autos, appliances and aircraft), and construction activity. Although these businesses have generated above-average growth in sales, earnings, and dividends compared to the market over the past few years, they have traded at below-average valuations. Important metrics for investors to track include realized pricing, cost of goods sold per tonne, sales volumes, capacity utilization rates, steel and aluminum prices, shipments, commodity (such as energy, iron ore, nickel, copper, alumina, and ilmenite/rutile ore) prices, adjusted EBITDA, as well as adjusted EBITDA margins. Standard valuation measures such as P/E, P/CF, and EV/EBITDA may be used to compare valuations between companies in this industry.

Mining

The mining industry extracts raw materials from the earth, such as coal, iron ore, copper, nickel, zinc, and precious metals. Mining companies may also process raw materials to a limited degree, but these materials are typically turned into finished goods by businesses in other industries. ESG concerns are becoming increasingly important, prompting mining companies to focus on reducing energy consumption, water usage, CO₂, NO_x, and SO_x emissions, minimize the environmental damage caused by certain activities like strip mining, and limiting the waste generated from operations. Investors should closely monitor company ESG ratings and regulatory risks. Economic factors that have the largest impact on industry sales growth and profitability include GDP growth, industrial production and capacity utilization rates, freight costs, industrial and agricultural machinery demand, heavy equipment demand, demand for durable goods (i.e., autos and aircraft), and demand for building and construction materials. Although these businesses have generated above-average growth in sales, earnings, and dividends over the past few years, they have traded at below-average valuations, possibly because of ESG concerns. Important metrics for investors to track include realized pricing by product type, cost of goods sold per tonne, sales volumes, utilization rates, commodity (such as oil, metallurgical coal, iron ore, ilmenite and rutile ore, nickel, copper, zinc, and gold) prices, operating costs, capital expenditures, tax expense, reserve life, exploration optionality, off-balance-sheet liabilities, tax structure, leverage (debt/EBITDA), as well as EBIT and EBITDA margins. P/FCF and EV/EBITDA are frequently used to compare valuations between companies in the mining industry, but price to net asset value (P/NAV), adjusted for off-balance-sheet items, may provide better insights into the valuation of companies whose value is largely dependent on reserves of raw materials.

Paper and Forest Products

The paper and forest products industry comprises one of the largest components of global trade. Companies within the industry produce lumber and plywood used in building construction, paper used for printing, and pulp, which is used to make containerboard, the primary component of boxes and other packaging materials. While pulp demand is dependent on the need for packaging materials and paper, lumber demand is driven by the homebuilding and home renovation markets. Deforestation remains a concern due to climate change and the beneficial impact trees have on absorbing CO₂ emissions from the atmosphere, so it is crucial that companies implement sustainable forestry practices. Economic factors that have the greatest impact on industry sales growth and profitability include the age of housing inventory, housing permits, housing starts, mortgage rates (which influence housing starts), tariffs, containerboard production, GDP growth, and employment levels. Despite having generated above-average growth in sales, earnings, and dividends compared to the market over the past few years, these businesses have traded at below-average valuations. Important metrics for investors to monitor include pulp, paper, and lumber sales volumes, cost of goods sold, EBITDA per mfbm (thousand board feet) shipped for lumber and EBITDA per mt (metric ton) for pulp and paper, cash costs per mfbm for lumber or per mt for pulp and paper, sales volumes, production and utilization rates, average net selling prices (pulp and lumber), adjusted EBIT and EBITDA margins, operating leases, as well as pulp, paper and lumber inventories. Commonly used measures to compare valuations between companies in the industry include P/E, price to book (P/B), EV/EBITDA, and EV/mfbm for lumber producers (or EV/mt for pulp and paper producers).