This is the third in a series of articles designed to find value in today’s stock market environment. However, it is the second of 10 articles covering the 10 major general sectors. In my first article, I laid the foundation that represents the two primary underlying ideas supporting the need to publish such a treatise. First and foremost, that it is not a stock market; rather it is a market of stocks. Second, that regardless of the level of the general market, there will always be overvalued, undervalued and fairly valued individual stocks to be found.
My second article was Finding Great Value In The Energy Sector. As a refresher, my focus in this and all subsequent articles will be on identifying fairly valued dividend growth stocks within each of the 10 general sectors that can be utilized to fund and support retirement portfolios. Therefore, when I am finished, the individual investor interested in designing their own retirement portfolio should find an ample number of selections to properly diversify a dividend growth portfolio with.
With the above second notion in mind, this article will look for undervalued and fairly valued individual companies within the general sector 15-Materials. Within this general sector, there are several subsectors which I list as follows:
My Selection Methodology
Before I go any further, an important disclosure is in order. I will produce a list of companies in this article (and all subsequent articles), that are names that I have hand-selected from a much larger universe. My selections were made by reviewing the individual earnings and price correlated F.A.S.T. Graphs™ on all appropriate companies that I identified within the sector. Some might say my method of identifying them was not very scientific, but I would counter that it was very thorough and comprehensive. On the other hand, I will admit to it being somewhat arbitrary and based on my own judgments.
Here is the basic method that I utilized. In order to find undervalued or fairly valued companies within the materials sector, I utilized the assistance of the F.A.S.T. Graphs™ screening tool in the following manner. First, I asked the screener to only look for companies within the sector 15-Materials. Then I asked to search for any company within the sector that had a current dividend yield of 1% or better. This is a slight deviation from my article on the energy sector, because I found it very difficult to find quality companies that I felt were in value within the materials sector that also had a dividend yield of 2% or better. Finally, I included ADRs and all companies listed on the Canadian stock exchanges.
This produced a gross list of 179 individual companies. Then I created a personal portfolio comprised of these 179 individual companies and sorted them in alphabetical order. Next, I reviewed the individual graphs of each company and either rejected it or added it to my final list of potential candidates based on whether or not I felt it had an adequate history and a reasonable level of consistency within that history. But most importantly, I looked for companies that I felt were reasonably valued, or close to it today based on current earnings and expected future earnings growth (or FFO for partnerships and trusts). Then I broke my refined list into two categories:
1. Conservative Growth and Income – 23 companies made this list.
2. Aggressive Growth and Income – 40 companies made this list
Before I present each of these lists, and featured selections from each, it’s important that the reader understands that these are prescreened lists of potential candidates prior to the necessary more comprehensive research effort. In other words, I am not recommending any of these stocks for current investment. Instead, I am recommending them as companies with historical records that appear reasonably valued, and therefore, worthy of investing the time and effort to take a closer look at. This was a challenge within the materials sector because of the cyclical nature of most of its constituents.
The Materials Sector: General Characteristics and Considerations
The materials sector, also known as the basic materials sector, is generally comprised of companies in the development, processing or discovery of raw materials. This includes the mining and refining of metals, the production of chemicals and forestry products
As I researched individual companies in the materials sector, it became abundantly clear that many of the companies within this sector possessed very cyclical operating histories that were generated based on one of two important factors. First of all, many of the companies within the materials sector are cyclical because, by their very nature, they are very sensitive to the state of the general economy. Consequently, their long-term earnings histories tend to be very cyclical because their underlying businesses are very sensitive to economic weakness. Second, many of the companies in the materials sectors fortunes are tied directly to the underlying price movements of the specific commodities their businesses are centered around.
The basic nature of the companies in the materials sector is a fact that any prospective investor must always keep in mind. Consequently, when I was reviewing each of the companies in the materials sector they reminded me of one of my favorite Aesop’s fables about the scorpion and the frog as follows:
The Scorpion and the Frog
A scorpion and a frog meet on the bank of a stream and the scorpion asks the frog to carry him across on its back. The frog asks, “How do I know you won’t sting me?” The scorpion says, “Because if I do, I will die too.”
The frog is satisfied, and they set out, but in midstream, the scorpion stings the frog. The frog feels the onset of paralysis and starts to sink, knowing they both will drown, but has just enough time to gasp “Why?”
Replies the scorpion: “I am a scorpion, it is my nature to sting…”
Other important characteristics that go hand-in-hand with what I described above relate to the growth potential of companies in the materials sector. For the most part, cyclicality also brings about low average long-term growth rates. Therefore, generally speaking, the best and most well-known companies in the materials sector tend to have low to moderate historical earnings growth rates. However, as with any rule, there are always exceptions. Nevertheless, you have to look very hard at the materials sector to find any companies that could be classified as fast, or even above-average growth companies. But there are a few.
Conservative Growth and Income Featured Selections
Frankly, it was difficult to classify companies in the materials sector as either conservative or aggressive. Due to the cyclicality mentioned above, and/or since many of this sector’s companies future prospects are directly tied to the price of the underlying commodity, it was difficult for me to not think of all of them as aggressive. On the other hand, in spite of the cyclicality of their earnings, most of the companies on the conservative list have consistent long-term records of paying a dividend without cutting it during economic weakness. But at the same time, it’s hard to find any growth with their dividends either.
Perspectives on Valuation
The following portfolio review lists the 23 conservative selections from the materials sector in order of dividend yield highest to lowest. Since as I previously mentioned, growth is hard to come by in this sector, stable dividends would tend to be an important component attracting investor interest. Consequently, even though all of these selections are also offered as appearing to be fairly valued, that doesn’t necessarily mean that they also represent good investments because of it. One of the benefits of reviewing this sector, is it gives me an opportunity to clarify an important principle regarding valuation and its relevance to return.
More simply stated, your future total returns are a function of both valuation and earnings growth. Consequently, it does not necessarily follow that simply because a company is technically trading at a sound valuation, that it can generate a high future return. Fair value represents the current soundness of your transaction based on the earnings yield that your purchase price corresponds to. Your future return, however, will be predicated on the future rate of growth of the earnings and dividends (if the company pays dividends). I have written a three-part series that elaborates more and these principles for any reader that is interested in a deeper understanding of these principles: