3 Value Plays In The Market’s Most Expensive Sector
The run in the S&P 500 since the election, accounting for more than 13% of the market’s 14.7% increase over the last year, has pushed stocks to rare valuations.
Stocks in the broad-market index are now trading at an average of 17.5 times analysts’ expectations for earnings over the next year, a premium of 25% on the 10-year average price-to-expected earnings. The optimism is in contrast to the fact that earnings forecasts are starting to come down, with analysts now expecting growth of just 9% when first-quarter numbers start coming out. This is considerably lower than the 12% earnings growth expected when the quarter started in January.
One sector in particular has boomed with last year’s stimulus in China and hopes for stimulus this year in the world’s largest economy. Bull markets don’t die of old age, and this one could be ready to move higher if Washington comes through with tax reform and fiscal stimulus.
I’ve found three value plays in a sector that stands to benefit directly from this upside. These three names will allow investors to participate in potential growth and should provide protection from downside risks.
Can Materials Build Off Recent Gains?
Morningstar calls recent Chinese demand that has boosted materials stocks “unsustainable” and estimates the sector is 44% overvalued, the highest among sectors it tracks. The Materials Select Sector SPDR (NYSE: XLB) has jumped 16.5% over the last year, outperforming the S&P 500 on investor enthusiasm and foreign stimulus. The sector currently trades for 18 times forward earnings estimates, a premium of 27% on the 10-year average of 14.2 times forward estimates.
#-ad_banner-#But cracks are starting to show for some of the market’s most expensive sectors. Fears that President Trump won’t be able to push his package of fiscal stimulus and tax reform through Washington have weighed against the materials group.
As of March 24, the materials sector has recorded the largest decrease in expected earnings growth among analysts tracked by FactSet Research. Earnings for the first quarter are expected 11% higher versus expectations at the beginning of the quarter for 20% growth.
More than half (52%) of the companies in the sector missed revenue expectations in the fourth quarter and four of the seven first-quarter pre-announcements have been for negative guidance on previous estimates.
Against the recent weakness, macroeconomic data has continued to support companies in the space. Economists surveyed by the Financial Times expect the United States to clear 2.3% GDP growth this year against just 1.6% growth last year.
The potential for a fiscal boost later in the year has continued to support materials producers. It could be the setup to a disappointing correction or the start to the next leg higher.
3 Value Plays With Room To Run
Few industries in the sector have as much to gain from promised infrastructure spending as cement and road aggregates. Industry-giant Cemex (NYSE: CX) estimates stimulus could push cement demand up to 6% higher in the United States this year versus demand growth of just 2% last year. The recent collapse of Interstate-85 in Atlanta has put new pressure on the government to fix our nation’s crumbling network of roads and bridges.
Summit Materials (NYSE: SUM) is a top supplier of aggregates and cement for infrastructure and roads in the United States. More than half of its earnings (60%) come from construction, especially non-residential, which could see increased demand this year on strengthening economic growth. Summit has a cost advantage over peers, as its cement plants along the Mississippi River allow for cheap shipping.
— Shares trade for 19.2 times forward earnings with profits expected 33% higher this year at $1.29 per share
— The company continues to benefit from net loss carry-forwards from the recession which act to shield current earnings from taxes
–Target price: $30 per share on earnings growth with limited downside on low-cost advantage
Prices for agricultural commodities have not risen as fast as others in the larger sector as crop production has been able to keep up with food demand. Even as global population growth slows, we are still adding 77 million people a year and income growth in developing nations has driven higher food demand.
Compass Minerals (NYSE: CMP) offers a rare combination in the materials space. The company produces de-icing salt and potash, giving it stronger year-round revenue against a typically seasonal business model. Mild winters in the U.S. Midwest have driven profits lower but the company is one of the lowest-cost producers in both products and a strong value play.
— Shares trade for 19.9 times forward earnings with profits expected 5% higher this year to $3.41 per share. The company has beaten expectations by an average 12% over the last four quarters
— Cash flow accelerated last year, supporting the 4.3% dividend yield, and the March blizzard in the Northeast could mean a beat on first quarter expectations
— Target price: $81 per share for a 19% gain on top of the dividend yield
Agrium (NYSE: AGU) plans to merge with Potash Corp mid-2017 to create the world’s largest agricultural nutrient company. The deal could combine the largest agricultural retail operator in the United States and producer in all three crop nutrients (Agrium) with the world’s largest fertilizer company by capacity (PotashCorp). The scale and retail distribution should drive pricing power and sales while cutting costs.
— Shares trade for 17.7 times forward earnings with profits expected 11% higher this year to $5.39 per share
— Shares pay a 3.5% dividend and the company generated $943 million in free cash flow last year, nearly 7% of its market capitalization
— Target price: $108 per share for a 13% gain on top of the dividend yield
Risks To Consider: Even value plays in the sector could weaken temporarily on a hit to investor sentiment for materials, but should rebound quickly on fundamentals.
Action To Take: Maintain upside exposure in materials while avoiding a generally overbought sector with these three leaders in the space.
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