Why Chemical Stocks Have Tanked—and 3 to Consider | Barron's Streetwise

Key Concepts

Upstream vs. Downstream Chemicals: Upstream refers to companies closer to the raw materials (like oil and gas) used to produce chemicals, often dealing with bulk products. Downstream refers to companies producing more specialized, higher-margin chemical products.
Industrial Recession: A period of decline in industrial production and economic activity.
Secular vs. Cyclical Components: Secular refers to long-term structural trends, while cyclical refers to short-term fluctuations in an industry.
Cost Curve: The relationship between the cost of production and the quantity produced, often used to compare production costs between different regions.
Capacity Expansions: The increase in the production capability of an industry, often leading to oversupply.
Dividend Yield: The ratio of a company's annual dividend per share to its market price per share, expressed as a percentage.
Operating Leverage: The extent to which a company's operating costs are fixed. Higher operating leverage means that a small change in sales can lead to a larger change in operating income.
Free Cash Flow Yield: The ratio of a company's free cash flow per share to its market price per share, expressed as a percentage.
Input Inflation: An increase in the cost of raw materials, labor, and other inputs used in production.

Chemical Stocks: Navigating a Divergent Market

This discussion delves into the current state of the chemical industry, exploring why many chemical stocks are underperforming despite a generally strong stock market. The conversation highlights the divergence between the booming AI-driven economy and the struggling industrial sector, with a particular focus on the challenges and opportunities within various chemical sub-industries.

Gold Market Volatility

The trading week saw a significant drop in gold prices, which had previously experienced a 65% year-to-date gain. This decline, about 6%, was the largest single-day drop since 2020. While technically gold was considered "extended," analysts suggest a potential for further short-term declines but maintain a constructive long-term outlook. This dual perspective reflects the inherent unpredictability of trading, which depends on collective future actions. The discussion briefly touches upon historical factors influencing gold, such as central bank buying and concerns about US federal debt, as well as its recent divergence from Bitcoin.

The Chemical Industry Conundrum

The central mystery explored is why the rising tide of the stock market isn't lifting all boats, specifically chemical companies. Several factors are identified:

Earnings Reports: Upcoming earnings reports for chemical companies were a catalyst for the discussion.
Depressed Stock Prices: Many chemical stocks have seen their prices beaten down, even as the broader market reaches all-time highs.
Outlandish Dividend Yields: Some chemical companies, like Lion Delbasel, have exhibited unusually high dividend yields (around 11% for Lion Delbasel), signaling potential distress or undervaluation.
Divergence from the Broader Economy: While the stock market and housing values are high, suggesting consumer wealth and spending, the industrial economy, which is a significant end-market for chemicals, is not performing as well. This is attributed in part to the "booming AI economy" overshadowing the industrial sector.

Upstream vs. Downstream: A Key Distinction

A crucial distinction is made between upstream and downstream chemical companies:

Upstream: Companies closer to the raw materials like oil and gas. Examples include bulk polyethylene, a building block for plastics.
Downstream: Companies producing more specialized, higher-margin products. An example given is a citrus-scented chemical (37 dimethyl 2methylene 6 octal), used in fragrances.

There is a significant difference in investment prospects between these two segments.

Matthew Deo's Analysis: Industrial Recession and Global Supply Dynamics

Matthew Deo, a chemicals analyst with Bank of America Securities, provides in-depth insights:

Industrial Recession: The industrial economy has been in a recession for several years.
End Markets for Chemicals: A large portion of chemicals are used in housing-related durables (refrigerators, washing machines, mattresses) and construction (paint, PVC pipes). Existing home sales are a key driver for these markets, typically spurred by rising housing prices and a stronger wealth effect.
Secular vs. Cyclical Pressures: The industry faces both cyclical pressures (related to housing and durables) and secular structural issues.
US Shale Gas Advantage: For a decade, booming US shale gas and ethane production has kept chemical raw material costs low, providing a cost advantage over regions relying on oil-based feedstocks. However, this spread has compressed as crude oil prices have fallen.
China's Self-Sufficiency Push: China has aggressively pursued self-sufficiency in chemical chains, leading to significant capacity expansions, particularly in refining and subsequent chemical byproducts. This has created a global oversupply issue, impacting Europe and now the US.
Shifting Demand in China: China's demand is shifting from housing infrastructure to data and energy infrastructure.
Post-COVID Demand Ebb: The strong demand experienced during COVID-19 for plastics (due to increased home living and disinfection) has subsided, leading to market rebalancing.
China's Build Cycle: A key question is when China will cease its construction cycle, which historically prioritizes employment over immediate profits. The optimistic scenario involves China peaking carbon emissions by 2030, potentially allowing for continued building in the interim.

Investment Opportunities and Challenges

Despite the headwinds, opportunities exist:

Upstream Commodities: Many pure commodity upstream companies are expected to face challenging years, with forecasts for further dividend cuts. While attractive yields may be present, caution is advised.
Downstream and Value-Added Companies: Traditionally strong businesses focused on innovation and higher value-added products, which are less dependent on high utilization rates, have seen their stock prices "derate considerably." These companies are trading at levels not seen in a decade.
Lack of Risk-Taking: Institutional investors are consolidating positions into fewer, "guaranteed growth" stories, leading to a lack of hunting for bargains.
Inconsistent Policy and Demand: Uncertainty in policy and local demand makes investment decisions difficult.

Specific Stock Recommendations

Matthew Deo highlights a few companies as potential opportunities:

Element Solutions: An electronic chemical company supplying chemistries for printed circuit boards and semiconductor manufacturing.
- Growth Drivers: A portion of sales goes to AI and data centers, experiencing over 20% growth. Legacy businesses (tablets, smartphones, desktops) are expected to improve next year.
- Valuation: The stock is considered cheap, offering two to three years of appreciable top and bottom-line growth.
- Key Metrics: Buying back stock.
RPM: A coatings company with well-known consumer brands like Rustoleum and DAP.
- Business Mix: While consumer and housing-related components are contracting, 65-70% of the franchise is tied to industrial and commercial construction, which is growing organically at 3%.
- Growth Drivers: Increasing exposure to data center and distribution center buildouts, offering turnkey solutions and cross-selling opportunities.
- Valuation: The story is not reflecting the existing growth at the low end of the cycle. Operating leverage is expected to improve, benefiting earnings.
Exalta: A company that paints a majority of new cars and has a significant auto refinish business.
- Market Dynamics: The auto refinish market is highly fragmented with good pricing power but is currently under cyclical pressure due to consumer wallet tightness and rising insurance premiums. This has created a backlog of work.
- Long-Term Outlook: The concern about autonomous driving reducing accidents is considered a long-term factor, not the current driver, given the average age of the US car park.
- Valuation: Trading at historically low levels, with a free cash flow yield near 10%.
- Future Prospects: Expected to initiate a dividend, has a clean balance sheet, and opportunities for reinvestment.

The Agricultural Chemicals Sector

The discussion also touches upon agricultural chemicals:

Farmer Income Pressures: Farmer incomes are not high due to input inflation (seeds up 25%, fertilizers up 30-40% since COVID) and lower prices for corn and soybeans.
Global Competition: Competition from strong harvests in Brazil and rising grain output from Ukraine exacerbates the situation.
Policy Impact: Tariffs and trade wars with China, as well as domestic policies like ethanol mandates and countervailing duties on fertilizers, play a role.
Outlook: Fertilizer prices are expected to fall next year, but seed prices are not. Policy changes, such as removing tariffs on fertilizers and improving trade agreements with China, could provide relief. Labor shortages are also a concern.

Conclusion and Takeaways

The primary reason for the underperformance of many chemical stocks, despite a strong overall market, is their tie to the struggling industrial and housing economies. Significant oversupply, particularly from China's capacity expansions driven by job creation rather than profit, further exacerbates the situation. This makes upstream companies more vulnerable. However, opportunities exist in downstream companies with higher-margin products. Investors are advised to be cautious with upstream segments and look for value in well-managed, quality businesses in the downstream sector, particularly those with strong growth algorithms and attractive valuations. The agricultural chemicals sector faces its own set of challenges related to input costs, global competition, and policy.