Searching for Great Stocks in Basic Materials

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Basic-materials companies with operations engaged in commodities, such as chemicals, steel, and aluminum, provide the resources needed to build and maintain our society. Since these materials go into everything from homes to automobiles, the underlying stocks are tied to the health of the global economy -- for better or for worse. 

It can probably go without saying that the past few years have been extremely volatile for stocks in the basic-materials sector. A slew of headwinds, including lingering unemployment and various debt crises, both in the U.S. and abroad, have resulted in the most unreliable corporate financial results since the Great Recession ended.

Many stocks within the materials sector haven’t rallied nearly to the extent of the broader market over the past few years. Therefore, now might be a perfect time to see if there are any stocks in the sector that are attractively priced.

One aluminum giant and Dow component

Alcoa (NYSE: AA) has had its share of struggles in the wake of the 2008 recession. As the financial crisis set in, global demand for aluminum quickly dried up. Since Alcoa is tied so closely to the health of the global economy, the recession took a huge bite out of its business -- a setback from which the company is still recovering.

Worse, 2012 was yet another difficult year, and Alcoa’s performance in recent years has taken investors on a roller coaster ride. Sales fell 5% in fiscal 2012 year-over-year, although the company faced tough comparisons. In 2011, Alcoa registered sales growth of 19% versus 2010.

Last year, Alcoa’s diluted earnings per share collapsed 67% to $0.18 per share. Based on 2012 figures, the stock looks to still be overpriced, trading for more than 40-times trailing diluted EPS.

However, the task for investors considering Alcoa is to predict the company's likely earnings this year and into the future. Based on the company's volatile results these past few years, that’s a more difficult task than meets the eye.

For its part, management has a fairly rosy outlook for 2013. Alcoa expects a 7% increase in global demand for aluminum this year, fueled mostly by emerging market demand that continues to outpace that of developed economies. Specifically, demand stemming from China and India is projected to grow 11% and 9%, respectively.

A hidden gem

Air Products & Chemicals (NYSE: APD) is not only a shareholder-friendly company in the materials sector but also when compared to the market as a whole. Very recently, the company raised its dividend by 11%, representing the thirty-first consecutive year for dividend increases. The new annual dividend of $2.84 per share amounts to a 3.2% yield at recent prices.

The company derives 60% of its revenue from outside North America, and reported full-year 2012 sales fell by about 1% year-over-year. Operating income and net income from continuing operations also fell 1% for the year.

Air Products, however, still achieved an 11.5% return on capital and an 18% average return on equity. While sales declines are rarely indicative of an investment-worthy stock, it’s worth noting that 2012 was an extremely challenging year for global-materials companies. Air Products showed resilience in a year in which global manufacturing continued to slow.

Do you have nerves of steel?

ArcelorMittal (NYSE: MT) is an intriguing stock for investors interested in international diversification. The integrated steel-and-mining company, based in Luxembourg, carries a $20 billion market capitalization and has a presence in 60 countries worldwide.

Unfortunately, 2012 proved to be an extremely difficult year for ArcelorMittal and its investors. The company reported a $3.7 billion net loss, driven primarily by a 2.3% drop in steel shipments.

That being said, management is more optimistic about this year than last. The company expects reported earnings before interest, taxes, depreciation, and amortization (EBITDA) to be higher in 2013 as compared with 2012. In addition, steel shipments are expected to increase by 2%-to-3%, and margins are expected to improve, as well.

Let shareholder returns be your guide

Air Products provides reliable annual dividend increases in the high-single digit to low-double digit percentages. Over the past five years, the company has increased its shareholder payout by 10% compounded annually. It seems that year in and year out, no matter how challenging the prevailing economic climate, Air Products comes through with a 10% dividend increase.

Alcoa has taken measurable steps to reduce costs and right its ship after facing the worst economy in 2008 and 2009 since the Great Depression, but more work needs to be done. Buying Alcoa in the current environment may be more of a speculative bet than many investors would likely prefer. The company’s operating performance fluctuates wildly from year to year as a result of volatile aluminum prices.

Alcoa slashed its dividend in 2009 during the depths of the financial crisis. Unfortunately for investors, the company hasn't  increased its dividend since then. Consequently, the current dividend amounts to a paltry 1.4% yield, hardly providing suitable downside protection.

ArcelorMittal still has a ways to go to recapture more solid financial footing, as well. To buy and hold this stock, investors must have the stomach for ups and downs that are inevitable with a global steel company. ArcelorMittal is currently trading 60% below book value, so investors who believe in the long-term direction of the company might not have a better opportunity than the one that exists today.

Had ArcelorMittal not altered its dividend policy, the stock would be a compelling opportunity. It paid 2012 dividends worth $0.75 per share. Unfortunately for investors, the ArcelorMittal's board of directors has recommended the dividend be reduced to $0.20 per share for all of 2013. While still subject to shareholder approval, a dividend reduction would offer investors a yield of only about 1.5% at recent prices.

As a result, Air Products seems to be the most promising of the materials stocks presented here. Air Products trades for only 15 times trailing earnings and offers a long track record of reliable dividend increases.

Robert Ciura has no position in any stocks mentioned. The Motley Fool owns shares of ArcelorMittal. 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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