Morningstar Advisor - December/January 2012 - (Page 29)

Collins: In agriculture, we’re actually still very healthy. The industry recovered nicely from a very severe downturn in 2009, and because of weather disruptions and still-strong demand, this is an industry that hasn’t yet started to suffer to the same extent as other industries from macroeconomic concerns in 2011. Building materials is an industry that, in developed economies, has never recovered from the downturn that began in 2006. It started to suffer with the bursting of the housing bubble in the United States, Spain, and other European countries, and what followed was a downturn in commercial construction activity and, very lately, weak government budgets in Europe and the United States. The outlook for infrastructure spending is more uncertain now. because it’s more about consumption than investment. Thermal coal production that can find its way there should continue to do well. Forest products is an industry that’s very similar to building materials; it’s even more leveraged to residential construction activity because lumber is used more in houses than it is in steel commercial structures. As a result, that industry has continued to suffer, but we’re looking favorably at timber companies in the Pacific Northwest because we think that there should be reduced supply from Canada resulting from destruction caused by the Mountain Pine Beetle and the ability to export Pacific Northwest production to China, which has a favorable demand outlook. Metals and mining is another China story, broadly speaking. China is a big consumer of metals, and prices have responded to those concerns recently. Copper started the year over $4.30, and recently we saw it brush with $3/ pound, which is danger territory. But $3 doesn’t necessarily make sense now if you consider how tight supply is, especially with major strikes and violence in Indonesia and Peru. But we think that copper prices above $3/pound for the long term don’t necessarily make sense because the major copper producers will bring a lot of capacity online. I’ll hand it over to Bridget to talk about steel. Bridget Freas: The overall demand picture for steel, on the surface, looks very healthy. We keep hitting record consumption levels, but that’s all been due to the growth of China. When you take China out of the mix, the demand picture still hasn’t fully recovered from the downturn of 2009, and that’s a result of continued weakness in the construction markets, which consume about half of all steel. Guziec: Can you take China out of the picture? Freas: Here’s the problem: The growth of China, on the demand side, has also correlated with the growth of China on the production side. In other words, if you’re looking at a steel The chemicals industry is one that broadly follows the economic cycle; it’s not different in the way that agriculture or building materials might be. So, if you’re looking for a shortcut with chemicals, you can say that it’s very much related to GDP growth. Coal has a pair of different trends—you have company in the U.S., the fact that China has gotten so big hasn’t really helped someone who’s not directly exporting to China. In fact, it has actually hurt—we have such high iron ore and metallurgical coal prices today because the miners didn’t anticipate how big of a need that China would have for those steelmaking materials. When you look at steelmaking companies in Europe and the U.S. that are still operating in a market that’s at 70% of capacity, they’re faced with record costs on the raw materials side. So, from an earnings perspective, I would say that steel companies outside of China are still lagging where they should be relative to the story that their shipments are telling. It’s certainly a recovery, but it’s slow—it’s two steps forward, one step back. I don’t think we’re going to get three steps forward until construction comes back, and it will probably be a few years until we’re going to see a full recovery in earnings, no matter what happens on the consumptions side, because we need to wait for raw material prices to normalize, which we expect that they will. Guziec: What would drive that? Freas: The miners are trying to get their supply to catch up with demand. That takes a few years. If you look at Vale VALE and Rio Tinto RIO and all the big iron-ore miners, they all have major expansion plans in the works, but those are still going to take a few years to roll out. In addition, if we do see the downside in China from a reduction in fixed-asset investment—that will bring down raw material prices. Guziec: The story revolves around making the mines bigger. Freas: If you look at Vale, which is getting 60% margins on their iron ore, yes. They’re trying to produce as much as they can as quickly as they can. That’s why it’s interesting that the market’s turning bearish on Vale, when it’s more profitable than it has ever been, I’d imagine, in its history. People look at thermal coal for power generation and metallurgical coal for steelmaking. Prior to very recently, everyone was very excited about metallurgical coal; firms were investing in metallurgical coal capacity, and investors were buying up companies that produced metallurgical coal because of China’s voracious appetite for steel and steelmaking ingredients. We were skeptical of that trend because metallurgical coal is so sensitive, in this case, to China’s fixed-asset investment. Our theses tended to play out this year, with the producers that leveraged up to purchase metallurgical coal production now being hurt severely. We tend to look more favorably at thermal coal producers, especially ones that have the ability to export their production to Asian markets. Even if China rolls over in terms of fixed-asset investment, the assumption would be that their use of electricity would tend to be more stable, MorningstarAdvisor.com 29 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Contents
Contributors
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012