Diversify materials to reduce volatility

The materials sector is one of 10 on the Toronto Stock Exchange and a way to diversify your investment dollars.  Materials represent nearly a quarter of the value within the TSX/S&P Composite Index and these hard assets are viewed as valuable because most have a limited supply.  When meeting with a new client, the best way we can begin explaining the materials sector is to break t down into four baskets.  We do this because even within the materials sector, the individual baskets can react considerably different during changing conditions.

Basket One: Precious Metals

The greatest weighting within the materials sector is precious metals, including gold and silver, and diamonds.  Most precious metals shares that trade on a stock exchange have more than one metal.  As an example, gold companies often end up with silver, or some other material, during the mining process.   However, it is possible to look at a company that is focused primarily on one material.   Most companies break down the percentage of each metal as a percentage of its operations.   People who focus on this basket are generally bearish on the markets.

Basket Two: Growth Materials

If you’re bullish on the markets, then your underlying belief may be that the economy will continue to grow.  You may see growth continuing either domestically or in other regions, such as emerging markets.  If the economy is expanding then various materials are needed, such as coal, nickel, cobalt, molybdenum, iron ore, zinc, and copper.  Like precious metals, there is a limited supply – as demand increases so should the price of the underlying material.  On the flip side, if global growth is expected to slow then you would expect these types of materials to decline in price.

Basket Three:  Agriculture and Fertilizer

Agriculture and fertilizer stocks have been growing in popularity in recent years.  A growing population and shrinking agricultural land space gives a good argument to have exposure to this area.  Rising food costs are one area that is consistently linked to higher inflation.  Extreme weather patterns, quality of crops, and economic conditions will play an important role in this basket.

Basket Four:  Other Materials

Forestry products are an example of a renewable material.   Foreign exchange rates, housing, and general economic conditions will have a direct impact on this material.  Uranium is used for power, medical devices, and other various industrial uses.  Uranium is also linked to nuclear weapons and has some groups strongly opposing its use, especially after some recent disasters.  Attitude towards the use of uranium and other costs of energy are key risks for this material.  There are also materials used in products such as cellphones and televisions, referred to as rare earth metals with names ranging from cerium and dysprosium to Thulium and Ytterbium.

Diversify Materials

Depending on which advisor you speak with, some may like to concentrate on materials from a specific basket noted above.  An example of this is a person who really feels negative about the economy and chooses to overweight gold.  This would be a targeted approach to materials and one would be speculating to some extent.  A diversified approach is to purchase materials stocks in more than one basket.

Volatility and Risk Tolerance

Prior to investing in any materials stocks we caution investors to understand that these stocks will be more volatile than other sectors.  People should have a medium to high risk tolerance prior to investing in materials stocks.   The TSX/S&P Composite Index is currently comprised of approximately 24 per cent in materials stocks.  We recommend you speak with your advisor about beta risk, and other potential risks prior to obtaining any significant weighting in this sector.

Producing Versus Development

One area that should be looked at from a risk stand point is whether the materials stock is producing or is in the development stage.  Companies that are in the development stage are higher risk.  As inflation rises, so do the costs of getting a start up mine to the completion, or development stage.  A huge amount of capital is required to develop a mine.  Looking at the current level of cash and the overall economy is essential to determine if the company could survive if times got difficult or the material being mined suddenly declined in value.

Small Cap Versus Large Cap

Nearly all materials stocks start out as small capitalized companies.  Getting the company to the stage that it can be publicly traded is the first hurdle.  On the opposite side, some of Canada’s largest companies are in this category.  The top ten large capitalized materials names in Canada are:  Barrick Gold, Goldcorp, Potash Corp of Saskatchewan, Teck Resources, Kinross Gold Corp, Ivanhoe Mines, Silver Wheaton,  Agrium, Yamana Gold, and First Quantum Minerals.

Growth Stocks

Most material stocks are considered growth stocks.  Developing companies and smaller producing companies do not typically pay dividends.   Some of the largest producing companies may pay a small dividend.  The underlying reason to purchase these types of stock is to obtain growth in the underlying share price.  In our opinion, investors who purchase materials (growth stocks) must periodically trade them in order to obtain profits.  This is even more important if the underlying company is cyclical.

Investment Options

Investors have various options when it comes to obtaining materials exposure.  Using gold as an example, one could purchase any of the following:  physical bullion, gold Exchange Traded Fund (ETF), gold Exchange Traded Receipt (ETR), gold closed end fund, materials mutual fund, or gold common shares.  An advisor can assist you with understanding the pros and cons of each approach.