Taking a Closer Look at Chemical Companies

By David Harper | December 05, 2005 AAA

Most of us think of chemicals as a traditional investment sector with limited growth opportunities. And much of it is. Many chemical companies produce commodity materials, consume lots of capital, and are hopelessly subjected to global forces of supply and demand beyond their control. Under such conditions, it's tough for a company to outperform and the best an investor can do is buy into a favorable upturn in the cycle (many industry observers do think that's where we are now, headed into an up cycle).

Certainly, many of the brand names have had a tough time bucking the challenges of commodity-based businesses; e.g., Du Pont (DD), BASF (BF), and Lyondell Chemical (LYO).

At the Investopedia Advisor, we like companies that have built some sort of economic moat when making selections for our Core Holdings portfolio and, although it may be hard to define a moat (although we tried in , A Look At Economic Moats - Part 1 and 2) it is easy to define its opposite: a company that sells commodities.

But the strong, recent fundamental performance of Dow Chemical (DOW) points to the more interesting side of the chemicals business. Over the last two years, Dow's stock is up about 40%. Year-to-date (2005), the stock is languishing, but I doubt it will stay down. The high growth is found in their business called Performance Plastics and Performance Chemicals. This is where advanced chemical products are finding all sorts of innovative, higher-margin applications in water treatment, pharmaceuticals, and construction.

If you think chemicals is a dull industry, think again. Scientists are constantly inventing new molecules toward new material applications that leverage already strong underlying growth in demand for basic chemical products. Regarding the underling demand, basic chemicals tend to track with GDP growth, but growth is faster in developing nations like China and India where they are building out their physical infrastructures and they need chemicals to do it almost as much as they need energy.

The chemical industry includes basic chemicals, specialty chemicals, plastics, and coatings. Basic chemicals include everything from paint to vinyl to foam packaging and PVC pipe. Specialty chemicals include a seemingly endless list of applications; e.g., additives that enhance the performance of fuel, water, and air; catalysts that improve agricultural processes; and pigments that enhance the taste or smell of food.

From a user or investor standpoint, as the science operates at the molecular rather than atomic scale, it is hard to distinguish from nanotechnology. For example, Cabot Corporation (CBT) makes a marvelously enhanced glass that is lighter, more diffusive, and better insulating than ordinary glass. American Vanguard Corporation (AVD) has been growing fast (stock is at its 52-week high) selling insecticides and herbicides.

Plastics are chemicals and I don't think I can overstate the importance of plastics going forward. Of all the new materials, I think plastics and advanced ceramics may offer among the best investment opportunities.

Plastic are of course everywhere, but they continually find new uses. Huntsman (HUN) makes plastic components and seals for bridges because plastic doesn't corrode like steel or chip away like cement. Huntsman only went public earlier in the year; they are about 20% below their offering price. They have about $12 billion in revenues and sell a roster of specialty chemical products. The stock could be unfairly punished on temporary, difficult economic conditions (e.g., hurricanes and high energy prices). On the downside, they are almost 60% family-owned, which is a bit too much family ownership for my taste.

Nova Chemicals (NCX) does not assume that plastic packaging (e.g., take-out food bowls) is a commodity business. They make super-thin, super-tough wraps and sacks with their advanced plastics. Their sales have almost doubled in the last three years. You can't even trust plain old PVC pipe to sit still, these days: Lubrizol (LZ) markets TempRite CPVC which is "a technologically advanced heat, fire and chemical resistant polymer that we developed to serve technically demanding applications not well served by traditional PVC and other commodity plastics." They have sales of $4 billion but their stock already up +40% in the last two years.

I screened for all traded chemical companies and charted them below. I excluded pharmaceuticals and companies with a primary focus on containers/packaging (a sector unto itself). The large green wedge is the smallest 150 traded chemical companies that collectively represent more than $100 billion in sales. Among these smaller companies is Symyx Technologies (SMMX), a recommendation in our Swing for the Fences Portfolio.

Not a cheap stock by any stretch (its valuation would easily precludes spot in the other portfolios), so be warned, but they provide the tools that enable their customers to innovate new molecules in many industries, including chemical. I don't have space here to elaborate on their many unique strengths and super-smart business model (think recurring revenues due to royalties and licenses with seven of the top ten chemical companies), but we think they could become quite a story.

There is bound to be some great investments in this group. I spotted a few more interesting companies, but please check the valuations: some of these have already seen large price increases. I continue to like Air Products (APD), even with its more expensive valuation. Admittedly, performance chemicals are only about one-third of their chemicals business, which in turn is only 25% of the company. The other 75% is industrial gases, but many of these markets are likely to see double digit growth because there will be strong demand for clean air and clear water products. So, you are indirectly investing in the fortunes of electronics makers and energy producers in several international geographies.

Westlake Chemical (WLK) went public a little over a year ago and the price has already almost doubled. You need to decide for yourself on the valuation, but with $2 billion in sales, a very favorable cash flow trend, and a strong product mix (one of the largest suppliers of ethylene and several vinyl products), they could be a solid investment.

Sigma-Aldrich (SIAL) is an exciting company that definitely warrants a closer look. Their longtime CEO hands over the title to a new CEO on January 1st after producing years of solid, disciplined financial growth and above-average returns (e.g., at least 20% ROE and pretax margins that somehow exceed 20%). Apart from this significant leadership change, the company has shared its go-forward strategy which includes several initiatives aimed to beat the average, ho-hum growth rates in core chemical business. They already sell about 25% of their business over the internet and I liked what I heard about their commitment to ecommerce.

These are just a few examples, I am sure there are more opportunities in specialty and performance chemicals!

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