XC smallcase Portfolio: MATERIALS sector

According to the ‘Global Industry Classification Standard (GICS)’, “The Materials Sector includes companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, and metals, minerals and mining companies, including producers of steel”. GISC divides the materials sector into five industries:

Chemicals

• Commodity Chemicals
• Diversified Chemicals
• Fertilizers and Agricultural Chemicals
• Industrial Gases
• Specialty Chemicals

Construction Materials

• Construction Materials

Containers and Packaging

• Metal and Glass Containers
• Paper Packaging

Metals and Mining

• Aluminum
• Diversified Metals and Mining
• Copper
• Gold
• Precious Metals and Minerals
• Silver
• Steel

Paper and Forest Products

• Forest Products
• Paper Products

The materials sector comprises of companies that tend to supply most of the materials used in construction. Hence, the companies and their respective stocks are prone to changes in the business cycle. They tend to thrive when the economy is strong but tend to lag when the economy is weak. The materials sector depends a lot on demand and supply. For instance, if the demand for consumer goods drops, the demand for raw materials that are involved in their production will also drop. Similarly, the materials sector is also affected by the real estate market. If the real estate market is doing well and there is demand for construction materials in order to build new houses, buildings, offices, and so on, the demand for such goods and services will increase. The reverse holds true as well, i.e. a decline in the real estate market would lead to a decline in the demand for materials.

Another extremely important factor to consider is that most of the raw materials occur naturally. A great deal of them are finite resources that take millions of years to develop. The ones that are renewable/reusable are not available in infinite quantities at one point in time. It is really important for one to keep these factors in mind because, at times, even if there is a great deal of consumer interest and demand for these goods and services, it might be completely possible that the available resources are not sufficient to fulfil their demands. To add to the above point regarding renewable and non-renewable resources, it is also essential to note that if the cost of discovering and producing materials increases, the costs of production and manufacturing would also increase, meaning that the price of the goods would be higher (the producer would need to pass on the higher charge on to the consumer to ensure that they do not incur a loss).

The chart above shows the economic cycle (both the market and the economy). As seen above, the materials sector does well when there is a bull market as well as when the recovery of the economy eventually leads the market to a top. As the market starts to enter a bear phase and the economy has completely recovered, there is rotation out of the materials sector into defensive sectors such as staples, healthcare, and utilities.

The diagram above is a representation of the economic cycle. As seen above, during a bull market and when the market is moving towards its peak, there is demand for materials since the economy is expanding and there is a need for greater infrastructure. However, when the market has peaked and is moving towards a bear phase, investors rotate out of materials and move to defensive and safer bets such as utilities, consumer staples, and health care.

These two diagrams make a lot of sense for someone who does not follow the market and is not aware about different market cycles because it is relatively straightforward to understand them. If the economy is expanding and the market is in a bull phase, there will be demand for materials since there is a need for better and greater infrastructure. During a booming economy, consumers have greater disposable income to spend and hence, are more likely to spend on goods and services than they would when they have a lower income. The increased demand means that the GDP of the economy would increase, leading the market to a new high, justifying why the materials sector does well during times of economic booms.

As an investor, there are pros and cons of investing in stocks that are a part of the materials sector. As indicated earlier, material stocks tend to follow the economy (i.e. if the economy is doing well, there will be demand for such products and hence their stocks would do well and vice-versa) and hence, they are extremely attractive investments during booming economic times. On the downside, the drawback of investing in material stocks would be that it would increase the volatility of one’s portfolio, since their demand depends on the state of the economy. During bear markets and when the GDP is contracting, they would not necessarily perform well.

All in all, in conclusion, it is important to consider all the above mentioned facts and arguments since they determine how the materials sector as a whole will play out. As indicated earlier, the materials sector performs very close in line with how the economy does. If the economy is doing well and expanding, the sector also tends to do well due to the increased demand for raw materials and the need for greater infrastructure. The reverse holds true. When the market is in a bear phase and the economy is contracting, investors would rotate out of materials since they have a lower disposable income and would likely spend that on necessities such as healthcare, staples, and utilities. The market and the economy move in line with each other, with each sector’s performance tied more or less to the stage of the economic cycle the economy is in. As an investor, recognizing the stage of the economic cycle that an economy is in is extremely vital in order to capture the trend following sectors and make investments accordingly.

Links:

MSCI GICS: https://www.msci.com/gics

First Chart: https://patternswizard.com/sector-rotation/

Second Chart: https://epsilonluxe.wordpress.com/2013/10/19/sector-rotation-study-october/

By Arhan Parikh (arhan.parikh@xumitcapital.com)