Basic materials bargains

Economic fears have hit these stocks hard -- too hard, in some cases.

By John Reese Jul 10, 2012 9:45AM

As Europe's debt crisis has flared up and growth in China has slowed from "gangbusters" to merely "impressive" in recent months, basic materials stocks have been hit hard. For the year, the sector is up less than 1%, according to Morningstar, lagging all other sectors except energy. And over the past three months, basic materials have lost more than 6%, also near the bottom of the rankings.

 

It's easy to understand why these stocks have been taking a pounding. Europe's crisis has dominated headlines and led to increased fears that eurozone woes will hurt U.S. exports and act as a drag on growth here. Similarly, less than expected Chinese growth has led to fears that the fast-growing Asian power won't be needing as much steel, iron ore, and other materials from the rest of the world as previously thought.

 

But while those concerns are certainly legitimate, investors often overreact in these situations, and fear -- not fundamental reality -- drives them to sell off good stocks. My Guru Strategies think that's been what has happened to a lot of basic materials stocks lately. These approaches, each of which is based on the strategy of a different investing great, are finding a lot of value in the sector.


If the fears about Europe and China end up being even only a bit overstated, good companies within the sector could end up producing a lot of upside surprises, making for some nice games for their shares. Here are a handful that my strategies think are good candidates for such a rebound.

 

Curtiss-Wright (CW): This New Jersey company's roots go back to the very beginning of air travel -- in fact, it is the legacy company of the Wright brothers (and Glenn Curtiss). Its shares have no doubt been hurt this year in part by the fact that the U.S. government -- which faces potentially dramatic budget cuts -- is a big purchaser of CW's flow control, motion control, and metal treatment systems and services. But CW has been growing its non-defense businesses, with more than 60% of its revenues in the first quarter coming from non-defense endeavors like the sale of products used in the commercial aircraft, oil and gas, and power generation industries.

 

CW gets strong interest from the model I base on the writings of the late, great Benjamin Graham, the man known as the "Father of Value Investing." This stringent approach requires that a company have a current ratio (current assets-to-current liabilities) of at least 2.0, and more net current assets than long-term debt. CW delivers on both fronts, with a 2.4 current ratio, and $571 million in long-term debt vs. $728 million in net current assets. It's also selling at a good price: Its price-to-earnings ratio (using three-year average earnings, which Graham did) is 13.1, and its price-to-book ratio is 1.12.

 

Cliffs Natural Resources (CLF): This Cleveland-based mining company is a major global iron ore producer and a significant producer of high- and low-volatile metallurgical coal. It has mines in North America and Australia, and a market cap of about $7 billion.

 

Cliffs has been hit hard since I wrote about it late last year, thanks in large part to the China slowdown. But boy is it cheap, trading for just 4.4 times trailing 12-month earnings per share and about 6 times projected 2012 earnings per share. It's a favorite of the model I base on the writings of mutual fund legend Peter Lynch. Lynch famously used the price-to-earnings-to-growth ratio to find bargain-priced growth stocks, and when we divide Cliffs' trailing price-to-earnings ratio by its 38.3% long-term growth rate (I use an average of the three-, four-, and five-year growth rates to determine a long-term rate), we get a PEG of just 0.12. That easily falls into this model's best-case category (below 0.5). Even if that growth rate slows to one-third its current level, Cliffs is so cheap that its PEG would still come in under the model's 1.0 upper limit.

 

The Lynch model also likes that Cliffs isn't loaded down with debt -- its debt-to-equity ratio is under 60%.

 

Potash Corporation of Saskatchewan (POT): This Canada-based firm ($39 billion market cap) is the world's largest fertilizer company, responsible for about 20% of global potash capacity. PotashCorp, which has a 24.6% long-term growth rate, is another favorite of my Lynch-based model. It trades for 14.0 times trailing 12-month earnings, which makes for a solid 0.57 PEG ratio. Its inventory-to-sales ratio has also been declining slightly, which the Lynch model likes to see, since a rising inventory-to-sales ratio indicates a company's products aren't in demand. And PotashCorp's debt-to-equity ratio is about 56%, far from excessive.

 

BASF SE (BASFY): Based in Germany, this global chemical giant ($65 billion market cap) is active all over the world. Its offerings include chemicals, plastics, performance products, crop protection products, and oil and gas products.

 

BASF shares have bit hit quite hard over the past few months, and when you look at the breakdown of its revenues, you understand why. The firm gets about 56% of its revenues from Europe (about three-quarters of that is from Germany), and another 18% from the Asia/Pacific region, so its business sits right near the heart of the global economic fears. But the firm is in solid financial position -- long-term debt is less than net current assets -- and two of my models think it's a bargain. My Lynch-based approach likes its 19.6% long-term earnings per share growth rate and 0.39 yield-adjusted PEG ratio (Lynch added dividend yield to the "G" portion of the PEG ratio for large dividend-payers like BASF). My James O'Shaughnessy-based value model likes the stock's size, $12.33 in cash flow per share, and solid 4.7% dividend yield. 

 

BHP Billiton Plc (BBL): London-based Billiton is a natural resources company that has more than 100 locations across the globe. It is one of the world's largest producers of major commodities such as aluminum, copper, coal, iron ore, nickel, silver and titanium minerals, and uranium, and also has substantial interests in oil and gas. (Note: BHP Billiton is a dual-listed company that also trades under the symbol BHP; my models are a bit more interested in the BBL listing right now.)

 

Both my Lynch- and O'Shaughnessy-based models like BBL. My O'Shaughnessy value model likes its size ($167 billion market cap), $9.97 in cash flow per share (which is more than seven times the market mean), and solid 3.8% dividend yield. My Lynch-based model likes its 17.5% long-term earnings per share growth rate and yield-adjusted PEG of 0.32. It also has manageable debt, with a debt-to-equity ratio below 40%, another reason the Lynch model likes it.

 

I'm long BBL and CW.


John Reese is the founder and CEO of Validea Capital Management and Validea.com and the author of The Guru Investor: How to Beat the Market Using History's Best Investment Strategies.

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