Today we continue our look at the sectors of the stock market with an overview of the Basic Materials sector. Feeding many industries throughout the rest of the economy, this sector centers on the extraction and processing of raw materials that aren’t included in the energy sector (oil/gas). Prominent industries categorized under Basic Materials include:
- Mining of everything from iron ore to gold. The second biggest industry in the sector by market cap.
- Metal refining, most notably steel.
- Building materials manufacturers.
- Forestry and Related Products, including paper and paper product firms.
- Chemical Production, the single largest industry in the sector by market cap.
While each of these industries has unique dynamics, we generally expect Basic Materials stocks to be starkly pro-cyclical. These firms largely produce commodities whose price depends on global demand. In a hot economy, prices on basic materials are bid up by growing firms, but supply can outpace demand when the global economy slows, leaving many materials stocks in dire straits. Expect hypersensitivity to the macroeconomic business cycle for Basic Materials stocks.
With their fortunes clearly tied to relevant commodity prices, it’s tempting to attempt straightforward analysis connecting the price of a commodity and a stock producing it. But, given the financial complexity of modern firms, these relationships can be far more tenuous than one might expect.
Because commodities are so homogenous, fierce price competition rules the day in this sector, which can cause some dramatic swings in value. Firms that can’t produce at prevailing market prices are either sold to competitors, forced to cease operations until prices rise, or declare bankruptcy. Concurrently, firms lucky enough to be able to produce at a strong cost advantage can rake in massive profits. Most industries in this sector are also highly capital intensive, so balance sheet analysis is indispensable. Debt loads accrued during commodity booms can become unsustainable when prices inevitably fall. This sector is also heavily globalized, with firms owning mineral rights, forests, and factories across the world. That means trade conflict and exchange rate risk are yet another salient factor.
Fortunately, all this volatility creates diverse and plentiful profit opportunities for news-based traders.
Mining stocks alone account for a notable portion of our top performing stocks. Just like with upstream energy stocks, a single promising report on the productivity of a mineral rights play can totally transform the value of a firm overnight. As in other sectors, mergers and acquisitions are another key
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