A focus on commodities

4/21/2008


Energy and materials stocks have outperformed the broader market by a wide margin in recent years, reflecting rising commodity prices.

The S&P 1500 Energy Sector Index has risen 24% over the last 12 months and 28% annualized over the last five years, while the materials index increased 7% and 18%, respectively. In contrast, the S&P 1500 SuperComposite Index posted annualized growth of 9% over the last five years and has fallen 9% over the last year.

Two words explain the superior returns of the energy and materials sectors: emerging markets.

Emerging markets provide a big boost to many companies, including several on our Focus List. PepsiCo ($71; NYSE: PEP) sells an increasing amount of drinks and snacks to newly prosperous citizens of developing economies. Accenture ($37; NYSE: ACN) boosts its profit margins by outsourcing and helping its clients do the same. Multinational companies turn to emerging markets because they can find growth beyond that seen in developed economies.

But emerging markets have been a particular boon to energy and
materials companies because as these economies increase consumption, their rising demand for such limited resources as oil and metals has outstripped growth of supply.

High prices for metals have gilded miners’ results over the last several years, and futures markets project historically high copper prices over the next two years. High prices for oil and natural gas have not only boosted revenue and profits for energy companies, but have also encouraged them to step up spending on exploration and production.

As explorers lay out billions of dollars in the quest for oil in deep waters and remote locations, companies on the receiving end of that spending are doing well. Transocean ($149; NYSE: RIG) operates the world’s largest fleet of offshore drilling rigs, commanding high rates for its vessels. The length of rig-rental contracts has increased in recent years, even at record high prices, pointing to a healthy market and giving investors confidence in future profits.

Futures markets project oil prices will remain above $100 per barrel for the next two years. Such prices should support continued strong spending on exploration and production, and Transocean already has a $31.8 billion backlog of equipment orders. Consensus estimates project per-share-profit growth of 65% this year and 18% next year, and the stock soared to record highs earlier this month. But Transocean still looks cheap at less than 11 times the 2008 estimate.

Another Focus List pick with a chance to profit from high commodity prices is mining giant Freeport-McMoRan ($106; NYSE: FCX). Copper should provide roughly 80% of revenue this year. Demand for the metal is rising, particularly in China. Freeport shares were volatile last year, hurt by fears that the housing slowdown would reduce demand for copper wire. Demand did weaken in the U.S., but emerging markets are more than compensating.

Because of production difficulties this year, miners are unlikely to satisfy global copper demand. This should keep prices well above historical norms. Such supply issues are likely to reduce miners’ volume growth. But even if projections for copper volumes prove too optimistic, Freeport seems capable of topping the market’s modest expectations.

Transocean is not the only Focus List Buy that allows investors to tap into a booming market indirectly. Manitowoc ($36; NYSE: MTW) builds cranes used for construction, energy, and other infrastructure projects. Emerging economies, which are spending furiously to build roads, factories, power plants, and airports, now account for roughly a third of the company’s sales. Demand for Manitowoc’s cranes remains high, and the company represents a back-door play on energy spending.

Manitowoc has also managed solid growth at its food-service equipment unit. Earlier this month, the company agreed to pay $2.1 billion in cash and the assumption of debt for Enodis, a British maker of fryer systems for restaurants, as well as ovens, cooling equipment, and beverage dispensers. Manitowoc shares slumped on the news, hurt in part by the size of the deal and concerns that it would decrease exposure to cranes relative to foodservice. But the Enodis purchase should reduce cyclicality and boost growth in future years.

Consensus estimates project sales growth of 20% this year and 12% next year, driving even faster profit growth. Yet Manitowoc trades at 14 times trailing earnings, less than the average of 18 for industrial stocks in the S&P 1500.


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