3 Undervalued Basic Material Stocks
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When it comes to basic materials, gold is no doubt the most popular. However, investors ought to consider diversifying in producers with exposure in aluminum and alumina. Through diversification, investors can hedge against the downfall of one basic material through the, perhaps accompanied, rise of another.
Alcoa (NYSE: AA)
If you are willing to take on significant risk, Alcoa may be the pick for you. It has double the volatility of the broader market but looks cheap at 12.7x forward earnings. A series of operational missteps have badly damaged the brand image. Third quarter performance was so weak that EPS estimates fell significantly from $0.15 one year ago to the nearly break-even point today.
According to Morningstar, despite the challenging aluminum market in Europe (which resulted in the company closing 291,000 domestic metric tons of domestic capacity that was previously idle), demand is not necessarily weakening. The firm is forecasting global aluminum consumption to gain 7% this year, and alumina prices are expected to improve as they become less correlated with aluminum. And even though downstream operations have been weak, restructuring efforts have enabled the company to meaningfully expand margins above historical levels.
In regard to alumina, the firm is particularly well positioned to deliver strong returns. With low industry-wide inventories, alumina prices are naturally high. Up until now, they have been largely linked to aluminum, which have kept prices artificially low. By delinking the two, Alcoa can not only generate high returns from its market leadership but also mitigate risk. This effort has been further reinforced by the company's divesture of slow moving downstream assets. Further, the company has concentrated existing downstream operations in areas of lower energy cost to expand margins. Penetration into Brazilian bauxite mining has also exposed the firm to cheaper labor and a steeper growth curve.
Newmont Mining (NYSE: NEM)
If aluminum & alumina is not your thing, I recommend hedging against macro uncertainty by buying gold and copper. Newmont is highly diversified across several geographies, including Australia, Peru, the United States, Indonesia, and Mexico, among several others. While production has fallen in Indonesian mines, the launching of Australian mines have offset the impact and deliver shipments to a rapidly expanding Asian-Pacific market. In fact, China recently surpassed India as the world's largest purchaser of gold. Meanwhile, the large gain in gold prices has caused domestic margins to grow by 2,800 bps to 44% from 2007 to 2011. Going forward, the main question gold investors will face is whether international debt crises abroad will become less of an issue and cause the precious metal to depreciate.
Fortunately, the company is diversified in copper, which mitigates this risk. Manufacturing plants have been set up in emerging economies to capitalize on low labor costs. Since copper has been undersupplied in recent months, Newmont is in a good position to take advantage of high prices.
It is precisely this reason why Newmont is more attractive to the market than Yamana Gold (NYSE: AUY), a purer basic materials play. Credit Suisse still forecasts Yamana's ROIC to grow from 9.1% in 2011 to 16.1% in 2013. Meanwhile, the company's war chest will grow to around $2 billion in net liquidity. Thus, I personally believe that Yamana will outperform through buying back shares for EPS accretion or taking over undervalued business for synergies.
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