Frank Voisin writes about value investing topics at http://www.frankvoisin.com
Brad Carr, a reader with extensive experience as a basic materials sector analyst at a value-focused fund, wrote the following introduction to valuing companies in this field.
If you have experience analyzing a sector (formal or otherwise), and would like to write a similar post, please get in touch with me here.
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For purposes of this post, given the different industries inside the Basic Materials sector, we will define a basic materials company as one that is cyclical in nature while producing a highly commoditized product.
The first order of business when undertaking analysis on this sector is to be clear in the understanding that, as mentioned, the products sold by these companies are commodities, and thus offer no real form of competitive advantage by nature of the product alone. Competitive advantages in this sector come in the form of being the lowest cost producer; either having cheap access to extraction/production processes, or regions which limit the transportation cost to the end consumer. Pricing power is nearly non-existent for almost the entire sector except for the point in the cycle when supply becomes constrained. However, outside of these periods pricing will be set by the producer with lowest marginal cost (i.e. the producer that has the lowest cost to supply the next unit demanded) leaving producers further up on the cost curve to operate at losses.
In respect to chemical and steel companies, there is extreme amount of operating leverage inherent in these business models due to the relative size and capital intensity of their plants. Margins will be low, and sometimes negative, unless there is sufficient volume produced to spread these fixed costs across a wide base, leaving enough profit margin potential between the fixed/variable cost per unit, and selling price per unit.
Within the past decade China has had some disastrous impacts on the global supply picture as they have been known to run their plants at losses simply to avoid laying people off. It is also worth considering the impact they have had in the global supply picture as they build out capacity in order to serve their domestic market. Much of this excess capacity can make its way to export markets at below marginal cost pricing, wreaking havoc on those market’s domestic producer margins. This has made it an extremely difficult period to analyze the profit potential of basic material companies as you must always consider the “Chinese” factor. The supply/demand picture is simply not working the way it should where producers above the marginal cost of production will shutter capacity (operating at losses for the time being) until either demand comes back, or their efforts to shutter capacity to bring supply/demand into equilibrium causes prices to rise. However, you can almost be sure that once the price rises to a level sufficient to make this capacity come back on-line, that it will. This illustrates the cyclical nature of the sector.
Due to this cyclicality, it is extremely important to identify those companies that have historically been the lowest cost producers, and then to focus your time on those. Not to say the highest cost producers won’t provide strong stock performance, as they most certainly will at times, but they also have a higher potential of financial distress. It’s all in the nature of the risk/reward outlook. Once identifying companies who have shown resilience in sticking around though multiple boom/bust cycles, I then look at typical margins through full cycles. It is important to understand where the current industry is in a cycle, as this will affect valuation levels of companies. You will often find that companies will trade at low valuation metrics during peak periods as their earnings are higher than “normal”, while trading at high valuations when the industry is in depressed parts of a cycle with earnings below “normal”. In general, it is important to identify what “normal” profitability is through a cycle, and apply these margin numbers to out-year forecasts. Unless you feel you can correctly predict the peak-to-trough path of cycles over time, it would be approximately right to begin by forecasting demand to row at a conservative estimate of long-term global GDP.
Once the normalized margins numbers have been conservatively estimated, one must be careful when going further in the analysis to estimate normalized cash flow or owner’s earnings that the capital expenditure, tax rates, and capital structure of the firm is consistent with a normalized environment. The reason for this is these companies, and especially those that have been around a long time, tend to initially react to periods of low demand by cutting their capital expenditure budgets in order to allow demand growth to catch up with current supply. It would be good practice to try to estimate the capital expenditures necessary to provide a certain level of supply to the market, and then arrive at a normal capex growth figure consistent with the same long-term global GDP growth estimate used to arrive at out-year sales forecasts. As far as valuation techniques for these companies go there is a wide range of approaches from DCF, to multiples-based, to net asset value based. Personally, I don’t emphasize one over the other but rather choose to do a variation of all three in order to find a range of values and as a check on the assumptions used in the other methods. When using multiples, I tend to gravitate to EV/EBITDA over P/E given the capital intensity variation across firms and their differing capital structures. In my opinion, the multiple should incorporate the less stable earnings of these firms, and be consistent with the same long-term GDP growth assumption as stated before which would tend to skew it lower than the market-wide index multiple in most cases.
As a value investor, often the best time to buy these companies is when everyone expects the world to be going to hell in a handbasket. By having identified the lowest cost producers prior to these moments of fear, you can find comfort with the conviction you are working with companies who have experienced, and survived, these depressed cycles over and over again. Also as a value investor, I choose not to participate when company valuations are predicting global demand booms. I understand the booms might come to be, and I could miss out on very nice stock appreciation. However, I also keep in mind Buffett’s first and second rules – don’t lose money. The probability of capital loss rises when good news gets baked into share prices, as that leaves significant downside when/if that good news never materializes. Also, remember the world is a fairly resilient industrial machine and there will always be demand for commodities arising from the basic materials sector.
For a more in-depth explanation on valuing cyclical and commodity companies I highly recommend Aswath Damodaran’s website where he has a great white paper on valuing such companies. The site is also a treasure trove of other useful data sets, valuation topics, and even materials used for his MBA valuation classes he teaches at NYU. His white paper on valuing commodity and cyclical companies can be found here.
– Brad Carr, February 2012
Frank Voisin writes about value investing topics at http://www.frankvoisin.com
