My career started in the late 90s. We were nearing the end of the technology stock bubble and I was looking for the next opportunity. My analysis pointed towards commodities—there was a significant lack of investment over the past decade and spare capacity was elusive, despite the emergence of BRIC countries (Brazil, Russia, India and China) and their insatiable materials appetite to sustain economic development.
This essentially led to the commodities boom in the early 2000s and the double-digit returns for the materials sector.
Fast forward to 2018 and to a much more mature materials sector. We may not see double-digit returns again, but we still expect moderate growth. With all the trade related headlines these days, we’re likely to see heightened volatility in the near term. Yet, earnings in the sector are expected to grow by 5-6% over the medium term, which is in line with historical performance. Generally speaking, we are currently not overly positive about the materials sector, however we believe opportunities within the sector do exist.
The peculiar case of Canada and Australia
Canada and Australia respectively represent about 2.1% and 1.7% of global GDP, and the presence of the materials sector is significant to both economies. The sector accounts for around 11.7% of Canada’s capital markets, and about 18.1% of Australia’s. For comparison, materials represent about 5.5% of global equities and 7.5% of emerging market equities. Earnings in the sector are expected to be steady, modest and more in line with historical averages. For these reasons (among others), we are tactically underweight Canada and Australia at this time via the MDPIM Global Tactical Opportunities Pool.
Despite the underweight, we’ve dug up gems in the sector. In the MDPIM Canadian Equity Pool, we’ve benefited from our holding in forest products company Canfor Corp., a global leader in sustainable lumber, pulp and paper and a North American leader in green energy production. Canfor’s stock price is up 60% over the past 12 months, compared to 12.5% for the broader S&P/TSX Composite Index.
In Australia, we own Rio Tinto Group and BHP Billiton Ltd., but are underweight in both. Earnest Partners, sub-advisor on the MDPIM International Equity Pool and the MD International Value Fund, added both companies a couple of years ago when both stocks were trading at a discount due to weak metals pricing. These holdings have provided our portfolios with some active risk mitigation over the past two years as both stock prices have rebounded.
Tariffs, tariffs, tariffs
The U.S. is at odds with most of the world as far as trade is concerned and the recent G7 summit in Charlevoix, Quebec didn’t do much to improve things.[CA1] The materials sector has not been immune—back in March, President Trump announced tariffs on steel and aluminum imports of which Canada was initially exempt, but these exemptions have since expired.
The U.S. accounts for about 75% of Canada’s exports, so any impediments to trade (NAFTA aftermath, additional tariffs for example) will impact Canadians. Australia enjoys more diversity among its trading partners, with China, Japan, South Korea and India representing about 35% of its exports. The announced tariffs on steel and aluminum[CA2] are not expected to have much of an impact on our portfolios, as our exposure is relatively small and largely international.
We are overweight in two metals names: Austria’s Voestalpine AG and Norway’s Norsk Hydro ASA. Both companies produce specialized metal products and as a result, their stock prices have reduced sensitivity to commodity price swings. Over the medium term as metals prices have been weaker, our positions in Norsk Hydro and Voestalpine have served us well, beating the MSCI EAFE Index over the past five years by 31% and 15%, respectively.
In contrast to our significant underweight exposure to steel and aluminum, we are overweight in chemicals. Givaudan SA, which manufactures flavours and fragrances, is a particularly interesting holding. According to Nielsen Research as quoted by Givaudan, 78% of consumer repurchase decisions for fine fragrances is based on scent, similarly, 45% of repurchase decisions for food is based on smell and taste. Fragrances and flavours represent only 0.5% to 5% of the cost of these products. In other words, Givaudan’s products are critically important inputs for these products, but not a big cost, giving the company significant pricing power to pass through any input inflation and maintain high margins.
The bottom line
While we may never see another commodities boom like the one we enjoyed near the beginning of my career, earnings in the materials sector have recovered from the recent turmoil of 2015. We also know tariffs will likely lead to more volatility for the sector. While our outlook for the sector is not overly shiny, we still see some sparkle of opportunity for some companies.
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