Basic Materials: How to Play the Recovery

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For many years now the basic materials sector has taken quite a beating.  However, in the end of November 2012 something appeared to change.  Many companies seemed to be stabilizing as talk of a Chinese recovery spurred some minor percentage increases.  Now one month later those gains continue to mount.  So is it time to jump into some high quality names in the basic materials sector?

Vale SA (NYSE: VALE) has been a popular stock to short over the last few years.  Even the famed short seller James Chanos was in on the action for some very healthy returns.  However, over the last month the short position in the stock has decreased well over 10%.  There are many reasons why this happened. For instance, the price was approaching book value.  Forward P/E is for the first time in many years lower than current P/E.  Also, valuations for Vale were far more attractive than competitors.  Finally, the China rebound, if true, could spell exponential returns for this position.

Vale is currently trading at $21.60, which is approximately 18% below its 52 week high of $26.87.  With a P/E of 9.49 and a forward P/E of 9.0, things are looking up for the future of Vale.  Below (Figure 1) we can see how Vale stacks up to the industry averages.

Figure 1:

<table> <tbody> <tr> <td>Valuation</td> <td>Vale</td> <td>Industry</td> </tr> <tr> <td>P/E</td> <td>7.20</td> <td>9.20</td> </tr> <tr> <td>Yield</td> <td>5.05%</td> <td>4.40%</td> </tr> <tr> <td>Dividend 5 Year Growth Rate</td> <td>25.97%</td> <td>20.37%</td> </tr> <tr> <td>5 Year Net Profit Margin</td> <td>35.70%</td> <td>18.80%</td> </tr> </tbody> </table>

What we see is an undervalued company that is returning money to shareholders at a greater rate due in part to its glorious 5 year net profit margins.

Cliffs Natural Resources (NYSE: CLF) is another stock that deserves some attention in the iron ore space.  If there ever was a stock ripe for a bit of speculative value investing this would be the one.  Cliffs has seen its stock price slashed over the past year.  A $100 stock in 2011, Cliffs is currently trading at $39.00.  Looking at the same statistics (Figure 2) as we did for Vale, we can see why this stock may seem attractive to value investors with a long term horizon.

Figure 2:

<table> <tbody> <tr> <td>Valuation</td> <td>Cliffs</td> <td>Industry</td> </tr> <tr> <td>P/E</td> <td>6.19</td> <td>9.20</td> </tr> <tr> <td>Yield</td> <td>6.50%</td> <td>4.40%</td> </tr> <tr> <td>Dividend 5 Year Growth Rate</td> <td>33.22%</td> <td>20.37%</td> </tr> <tr> <td>5 Year Net Profit Margin</td> <td>19.40%</td> <td>18.80%</td> </tr> </tbody> </table>

Cliffs is a major producer of metallurgical coal, and since steel demand has recently been rising along with a 16% price increase over the last month, Cliffs stands to benefit in both iron ore prices and metallurgical coal.  However, I must approach this one with a bit of caution.  While I peg this position as the one poised to gain the most, it could lose the most as well if the Chinese bull market fails to materialize.

Finally, there are some very obvious calls if the Chinese bull run is really about to begin.  The larger materials producers such as Rio Tinto PLC (NYSE: RIO), Freport-McMoRan Copper and Gold (NYSE: FCX) , and BHP Billiton (NYSE: BHP) are all poised to prosper.  Looking at the chart below (Figure 3) we can clearly see how these materials producers are almost in perfect step with the Chinese markets.

Figure 3:

<img src="/media/images/user_14634/fxi-and-materials_large.png" />


If the Chinese bull market is really about to materialize, as many predict, it would make sense to own a couple of the names that would greatly benefit  from increasing demand for the raw materials necessary for China's growth.  While there are clear value plays in this sector, I am not going to be so bold as to call a single winner.  This is a macro-economic call where the rising tide will lift all boats and well-run companies will benefit.  For a bold call try Cliffs Natural Resources.  For a conservative call try FCX, since the gold mining and new oil operations may provide an element of safety given the projections for global inflation.

Lulupoopsalot has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold, Inc.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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