Morningstar Advisor - December/January 2012 - (Page 39)

require greater fertilizer applications. Therefore, producers of potash fertilizer stand to benefit, and global production is highly concentrated in the hands of a few players. Further, China has to import a significant portion of its potash requirements because of its lack of high-quality domestic deposits. On this basis, and in combination with its lower-cost resources, we believe Potash Corp. POT has a wide economic moat. Potash also owns a 22% stake in Sinofert, China’s largest fertilizer importer and distributor. Meanwhile, Monsanto MON will benefit indirectly from China’s supportive influence on global crop prices, although the firm’s direct involvement in China is only a small part of its overall business (in the form of vegetable seed sales). Growing electricity needs to power consumption would bode well for low-cost thermal coal producers. We expect China’s voracious and increasing appetite for thermal coal imports to be a secular trend. More consumption means more lighting, appliances, air conditioning, and space heating, and China’s electricity generation capacity would have to follow suit. While coal-fired generation will likely lose share to sources such as nuclear and gas-fired generation, expected strong growth in overall generation demand means coal plants will still need to be added. Moreover, rising domestic costs and internal infrastructure, transportation, and political issues are making it more difficult for China to be self sufficient in thermal coal. Infrastructure constraints in Australia, South Africa, and Indonesia are restricting these traditional exporters’ ability to meet that demand. The Powder River Basin of Wyoming has ample low-cost thermal coal reserves, but until recently, this coal had not found its way to Asia because of the huge shipping distances involved. However, thanks to the rise in Asian coal prices in recent years, the Powder River Basin has the potential to be a major player in the Pacific Basin as a critical “pressure release valve” swing producer. Cloud Peak CLD is the largest Powder River Basin exporter, and both Arch Coal ACI and Peabody Energy BTU are pursuing port-development projects. Peabody, Arch, Cloud Peak, and Alpha Natural Resources ANR control nearly 100% of the Powder River Basin, which contains some of the largest and most accessible coal deposits on the planet. Cloud Peak is the pure-play on the Powder River Basin, and we award the company an economic moat. Powder River Basin production also makes up a significant portion of Arch’s and Peabody’s overall production, and we think these two companies have economic moats, thanks to that low-cost advantage. Further, Peabody is investing heavily in Australian coal to meet China’s growing demands for both thermal and metallurgical coal imports. We caution that both Alpha and Peabody have metallurgical coal exposure, which would come under threat should China shift away from fixed-asset investment. As a nation’s middle class grows in size, the convenience and need for paper products likewise expands. Toilet paper, tissues, and paper towels are parts of consumers’ daily lives that are unlikely to be significantly curtailed by a slowdown in fixed-asset investment. Global demand for tissue should steadily increase for many years to come, thanks in no small part to growing consumption in China. Fibria FBR, the Brazilian pulp giant, is poised to capture this growth. More than 50% of the demand for Fibria’s pulp comes from global tissue manufacturers. More wealth would mean more gold jewelry and investments. The growing middle class in China is spending some of its newfound wealth on gold. Many factors influence gold prices, so a rebalancing of the Chinese economy would have an indeterminate effect on gold prices, in our view. However, to the extent that other forces in gold markets remain generally favorable in the long term, additional demand from Chinese consumers can only help. Eldorado Gold EGO is the only gold miner within our coverage universe to have an economic moat, and mines in China are one key contributor to its low-cost advantage. Eldorado has a significant presence in China, a country that most Western gold miners eschew. Economic moats in mining are almost entirely predicated on sustaining a low-cost position, which in turn depends on three major factors: low production costs, long reserve lives, and prudent capital allocation. Eldorado scores near the top of the industry on all three of these metrics, which should help the firm to generate economic profits throughout most of the gold-price cycle. Rebalancing “losers” include metals, metallurgical coal, building materials, and, to some extent, chemicals. In 2010, China consumed more than 35% of the world’s aluminum, copper, steel, and zinc. Much of this metal finds its way into electrical wiring, pipes, siding, and beams. These metals would suffer from a slowdown in China’s capital expenditures. Aluminum’s pain would be mitigated by the fact that consumption is a major end market— think aluminum beverage cans and automobiles. And while weakness in Chinese steel consumption would have negative effects on U.S. and international steel companies, the fallout would likely be moderated by lower input costs. China will play a pivotal role in the fortunes of the global seaborne metallurgical coal market. While China’s metallurgical coal import volume remains modest compared with the roughly 500 million metric tons the Chinese steel industry consumes annually, it is large relative to the 200-million-metric-ton global seaborne metallurgical coal trade. Continued growth in Chinese steel production, if not matched by domestic metallurgical coal output, would have major consequences for the seaborne market. On the flip side, a reversal in the nonstop expansion of Chinese steel output would have deleterious consequences for the seaborne metallurgical coal market, making sub-$100-per-metric-ton prices a distinct possibility. Building materials producers within China would suffer from a slowdown in fixed-asset investment. However, Chinese cement production contributes only a small portion of global cement producers’ profitability. We think the infungibility of MorningstarAdvisor.com 39 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