Don't Avoid Chemical Stocks, Just Diversify to Hedge

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

While it is no secret that chemicals have taken a beating from the weak economy, investors would do well buying and holding the subsequently discounted stocks. To spread out risk and not wipe out your earnings, I encourage diversifying in a mixture of takeover targets, beaten down producers, and undervalued high-growth producers. Below, I review 3 chemical stocks with this interest in mind.

Bears Too Bearish On Dow Chemical (NYSE: DOW), Missing The Point

At 12.4x forward earnings, Dow looks cheap. It is forecasted for 6.3% annual EPS growth over the next 5 years and has a stellar 4.2% dividend for a combined return of 10.5% assuming multiples just hold steady. The mean analyst rating has fallen from 2.94 three months ago to 3.06 today, where "1" is a "strong buy" and 4.1-5 is a "strong sell." 14 of 17 analysts rate the stock a "hold" or worse--2 of which say "strong sell." So, why the bearish sentiment in light of the low multiples?

Dow is struggling against a slow-growth macro environment. It plans on selling units that generate $1 billion in revenue, so it can maintain financial targets. Coatings, materials, electronics, and international ethylene have all trended poorly. In a state of downfall, management will lay off thousands and shut down 20 plants. This is now the second restructuring in 2012, and it reflects weakened demand, particularly in plastics. I believe the worst has been factored into the stock price and that the market has not properly accounted for management's adjustments. According to the CEO, Dow will "stop future growth projects that are no longer affordable" and put its focus on projects that can generate "positive returns in the far-distant future." These projects include greater ethylene volume on the Gulf Coast and chemical manufacturing in Saudi Arabia. For now, the restructuring initiatives will generate $500 million per year in savings by 2014's end.

Although operating margins have been eroding, management is still cutting corporate overhead and scaling back to improve efficiency. But after significant market deterioration in the second quarter and a slower-than-forecasted environment in the second half of 2012, investors are struggling to see the long-term. For those that buy and hold now, the upside is strong.

Diversify With Huntsman (NYSE: HUN) and Ashland (NYSE: ASH)

The consensus theory amongst financial economists is that riskier assets outperform. But just like you don't want to put all your eggs into one small cap stock, you certainly don't want to put all your eggs into a chemical stock. Huntsman and Ashland are two firms to consider--the former is even being cited as a potential takeover play. In fact, Huntsman has had an 18% return over the past six months, largely as a result of increased speculation.

In the third quarter, Huntsman beat consensus EPS by $0.19 with $0.70 in profit per share. Shares rose 4.8% from the announcement even as revenue missed $160 million from an 8% year over year decline. And unlike Dow, the company is looking to expand. It has considered increasing the scale of the Geismar plant to increase volumes in a chemical compound that helps make polyurethane foams. This move will help capture a rising demand for foam insulation. The stock trades at only 7.8x past earnings and 9.2x free cash flow. With business faring better than competitors, forecasts for 7.4% annual EPS growth, and a 2.4% dividend yield, this is a compelling business to invest in.

Ashland has very bullish sentiment on the Street with a rating of 1.8 out of 5. On Dec. 5, Deutsche Bank reiterated its "buy" rating and even increased the price target from $85 to $90. This new price target is at around a 20% premium to the current market assessment. What makes Ashland so attractive, in my view, is its steeper growth curve compared to peers. Consensus estimates forecast EPS growing by a rate of 12.9% over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $12.95. At a multiple of 12x, this translates to a future stock value of $155.40. Discounting backwards by 10% yields a present value of ~$96.50. This implies the firm is nearly 30% undervalued. This combination of superior growth and undervaluation warrants "buying," especially if you also want to invest in Dow and therefore need to hedge against the latter's collapse in plastics.

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