Why Chemical Stocks Have Tanked—and 3 to Consider

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks. Thanks for hopping on the phone during your week off.

Oh, happy to.

How's your week going?

I'm, I'm in full puttering mode. I had a, I had a big list of things to do. Um, I, I don't know why I put off tight— I had a couple of cabinet doors needed tightening in the kitchen that I put off for months. I thought it was a big job. Turns out I just had to turn a couple screws a little bit. The whole thing took not even a minute. I was embarrassed for having left it for so long. And then I have replaced a couple of— I'm a little confused about the difference between a baluster and a spindle, but, um, they're the wooden up and downy things on staircase, under the railing and the staircase. I replaced a couple of those. So, you know, it's a big week and I've been accumulating property pretty aggressively in the Monopoly game they're running at McDonald's. So we've got, we've got, it's too much to talk about.

I didn't know they were still doing that.

You know what? I just peeled one off as we're speaking here from the large coffee and it says you won food. Now I have to scan it to see exactly what we're talking about. I don't want to say more. It's going to start to sound like an advertisement, but it's just, there's a lot of excitement over in this corner. We're going to play a conversation in just a moment about chemical stocks. I have almost nothing to say about the trading week so far. I noticed that gold took a beating for a day. It had been up 65% year to date. It had its biggest single-day decline since 2020. That sounds more dramatic than it really was. It was about a 6% drop. And I've read a lot of research reports on what happens next. And if I had to combine them all into one report, it would say something like, Well, gold was technically extended in recent trading, so we wouldn't be surprised if there were a further decline now. But in the long term, we think it's still constructive for gold to move higher. Basically, a lot of strategists saying two things at the same time: could go lower, could go higher. No one really knows. And that's because trading depends on what you and everyone else like you does next. And sometimes that's a hard thing to predict. In fact, all the time it's hard. We've talked already about buying of gold by central banks. We've talked about the debasement trade or concerns about the US federal debt. Just recently we talked about how Bitcoin had fallen off and gold was still rising. I don't have anything new to add on the subject. I'm going to keep an eye on it. If anyone asks, just remember, tell them you're cautious on the short-term technicals but constructive on the longer-term fundamentals. That way, when we figure out where it eventually goes, you'll have been right either way. But I'm giving away too many Wall Street secrets now. Let's get to chemicals. That was the subject of the column I wrote last week in Barron's. Why chemicals? A few reasons. First of all, they had earnings reports coming up. Second, the prices had been beaten up. This is at a moment where the stock market's hitting all-time highs. One chemical company, LyondellBasell, had turned up in a recent search of companies with outlandish dividend yields. It had the highest yield in the S&P 500, around 11%. There were other chemical companies not far behind. So all that just got me curious. Why isn't a rising tide lifting all boats? If earnings growth is good, if stocks are doing well, if consumers are presumably feeling okay because of a wealth effect, their stock portfolios and house values are riding high, then why isn't that extending to chemical companies? And there are a bunch of answers, as we'll hear in a moment. One of them is that this booming economy is really a booming AI economy. The industrial economy is not doing quite as well. But let me let Matthew De Yeo tell you about that. He's a chemicals analyst with Bank of America Securities. I spoke with Matthew about plastics and agricultural chemicals and specialty chemicals and upstream versus downstream. I always have to think so I don't get my streams confused. Upstream is where we're talking about closer to the products that the chemicals are made from, like the oil. And downstream is where we get more specialized, higher margin products. There's a big difference at the moment between investing in upstream companies and downstream companies. I think bulk polyethylene, that's a building block of plastics. I think that would be an upstream product. I don't want to get angry email from the chemists. I think a downstream product, I, what was that one I gave a shout out to in my column, Alexis?

Oh, you're going to make me say it? Okay. 3,7-dimethyl-2-methylen-6-octanol.

Excellent pronunciation. That's used to make stuff smell like citrus. And I think it's downstream. What do you think, Alexis? Is that enough setup for now for our conversation?

Yeah, I think you really piqued their interest with the citrus thing.

Citrus fans can't believe their luck right now. Okay, let's hear from Matthew.

Broadly speaking, we've been in a few years of an industrial recession at this point, and a lot of chemicals ultimately do end up in housing. So if you were to think of durables like refrigerators and washing machines to mattresses, you know, the Tempur-Pedic mattresses, things like that, but also paint for walls and PVC pipe. For water and sanitation. It's a pretty large end market for what chemicals end up getting sold into. And existing home sales is a typically really good driver for that. When you sell your house, you typically invest, you put money into it to build the value up, and when somebody buys it, they tend to do some renovations. And so it's often a catalyst for reinvestment. Typically these happen when housing prices are accelerating and wealth effect feels stronger. People feel like they've got a little bit more disposable income, so it goes a long way. The difference is in, in what the industry is going through is you have the cyclical component, particularly on the durables and construction side, but then you have a more secular structural component. We've come off about a decade of fantastic profitability for the chemical industry. US shale gas and ethane, you know, production has been booming and you can't, or we have not been exporting enough of that to, how I say, disadvantage us domestically. We have enough supply of this stuff to keep chemical raw material costs really low.

In other words, if I understand you correctly, for many of these things you use oil or gas as some kind of initial feedstock. In some parts of the world, maybe they use a more oil-based feedstock, or maybe they use pricier natural gas. But here in the US, we have a lot of cheaper natural gas and that gives us an advantage in producing these chemicals. Do I have that right?

Yeah, precisely. And so the cost curve or the, you know, the price or the cost it takes to make a product in the US versus China often depends on the raw material. And in the US we use cheap gas and around the world it's oil derivatives or oil-linked, you know, byproducts. And so if gas is $3 and barrel of crude's $100, you've got a pretty wide spread. You know, crude price is now down to 60. So we've seen that spread kind of compress, if that makes sense. The other side of this is China has really started to push for self-sufficiency across a lot of chemical chains. And this has happened over time with different resources. It happened last decade with steel. And what they do is they'll go through investment cycles. And this started really with the refining boom. China added a considerable amount of refining earlier this decade, and chemicals became a sink for a lot of the byproducts off the back of the refinery. So we had a big wave of chemical capacity expansions in China that's actually still kind of going on. And so what's happening more with the petrochemical market is not so much just a US economic issue. It's more of a global issue. Demand in China is— how should I say this— changing the shape or the structure of demand. It's more data infrastructure, energy infrastructure, less housing infrastructure. We're also still working through what was a pretty big boom time during COVID Everybody was disinfecting everything and eating out. It's a very You know, living from home is a very plastics-intensive life. That's kind of obviously come off. But we had this kind of false sense of really strong demand that has since ebbed, and it's taken the market some time to kind of rebalance. Unfortunately for everybody involved here, the question is, when does China stop this build cycle? I mean, historically, the mantra was we build these projects for employment. We work towards employment, employment being the most important thing and profits kind of coming later. I mean, unfortunately, the optimistic scenario is China has kind of said to the world, we're gonna peak carbon emissions by 2030. Still a few years away, but it seems like for now there's a bit of a green light to build what you can and get that in the ground. And it's just creating a, a backstop of excess supply, which has actually really been impacting Europe and now is starting to feel the ramifications in the US. That was a long-winded answer. I apologize.

No, no, it's perfect. You've solved a mystery for us already. And the mystery is here in the US, you know, an ordinary investor is looking at their rising 401k account and seeing all this spending on data centers and AI and a lot of excitement there. And they look at earnings growth for the S&P 500, everything seems to be going fine. Their house prices are up, people feel wealthy, people are spending. So they say, if they look at the chemicals industry, they say, why isn't a rising tide lifting all boats here? Why isn't the chemical industry prospering to, to the same extent? And the answer, as you've just described for us, is, you know, it's a mix of things, right? The housing market here is maybe a little locked up. Maybe that's related to mortgage rates or other factors. There's some come down from some unusual activity during COVID There's a lot of new supply coming online overseas, particularly in China. So that makes sense to me. That leads me to the question of when we look at the chemicals industry, the various sub-industries, do any of these look like bargains right now? Prices seem low. Some of these stocks have high dividend yields. Do any of these pockets of the market look attractive enough to buy in now?

I mean, some of the pure commodities are still due for a few challenging years, and so we don't really have many buy ratings in what we consider to be like the upstream commodity franchise. There's a lot of attractive yields, but we are also forecasting a few additional dividend cuts.

So when you say upstream, upstream is like closer to the original feedstock. So I think of bulk chemicals, like, is that like the agriculture or the fertilizers and the things that later become plastics? Is it that sort of thing?

You can think about it that way. The dynamics for fertilizer can be a little bit different, but yes, when I think of upstream, it's base plastics. Plastic pellets that will then get blow molded into various other packaging items. But that's kind of where you see China adding the most pressure. The interesting thing is like a lot of traditionally good businesses, what we consider to be higher value add companies that deliver innovation, that don't have these big fixed cost bases that need to run at really high utilization rates to make profits., but actually have a little bit of cyclicality to it, work with industrial production, whether that's metal coil, whether that's aerospace or cars. A lot of these stocks have derated considerably. They're trading at levels they haven't traded at 10 years, maybe. It's really interesting. And I've been on the road a few weeks with my European colleague and he sees the same over there. Businesses that traditionally, used to have a bid to them because of the quality of the franchise have kind of been left for dead. And what we kind of, or what I have witnessed is a real lack of risk-taking amongst larger institutional investors. And they've been consolidating their positions into fewer and fewer stories that have stronger, how do I call it, growth algorithms. So you always kind of have this guaranteed growth. And without that, everything has been left by the wayside.

Not a lot of people out there hunting for bargains right now.

No, no, really not. I mean, there's seemingly an appetite to do so. We're having a lot of constructive conversations, but whether that actually turns into action depends a little bit on the outlook. And unfortunately, everything is pretty inconsistent from policy in Washington to demand at a local level. So there are areas and companies that we do see as strong growth vehicles that are maybe underappreciated or just being mispriced. So yes, we do think there's opportunities. I mean, our favorite story right now is an electronic chemical company and they sell chemistries for printed circuit boards and semiconductor manufacturing.

What's the name of the company?

Oh, Element Solutions. They have a portion of their sales that go to AI and data centers, and that's been growing very well. But I, you know, the market for semis and PCBs goes to tablets, smartphones, desktops, laptops, and seemingly remember where everybody's working from home, there being a period, everybody armed up and they bought 8 tablets for their kids. And you know, it's taken a little bit of time to move through that, but we expect these legacy businesses to improve next year finally. And you supplement that with the AI data center that's closer to 10 to 15% of their electronics business. That's growing excess of 20%, you have a real good growth algorithm and they're buying back stock and it's a cheap enough story for an exposure that we think creates 2 to 3 years of very appreciable top and bottom line growth.

I think we've broken 7 out of the 8 tablets that we bought. So when that last one goes, there could be a demand upswing.

There's definitely a refresh cycle to this for sure.

Thank you, Matthew. Let's take a quick break, and when we come back, we'll hear about some stocks that Matthew thinks represent good opportunities now for investors.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back. You know, I never told people who we were when we started this episode. You think people are thrown?

Yeah, I'm Jack Howe.

And I'm Alexis Moore. We're talking chemistry. You want to hear a potassium joke?

Always.

K. Wait, give it time because some people are still Some people are still— see, symbol for—

okay. Feels like a Snapple bottle joke.

I wish that game— Snapple wants no part of acknowledging that. We're talking with Matthew De Yeo. He's a chemicals analyst at Bank of America Securities. And Matthew says, even though chemical stocks, many of them have traded down a lot, they're not all good deals right now. Some of them could have further to fall, but there are a handful that Matthew likes. Let's hear about some of those now. Can you tell me about any other companies that you like right now?

Yeah, look, we just took this company RPM to buy. You would never know the name RPM, but you come across its brands fairly consistently, particularly on the consumer side. It's a coatings company and it's almost like a holding company for a number of brands. Rust-Oleum would probably be the number one. And if you've used spray paint before, you've most likely used a Rust-Oleum spray paint. DAP, Zinsser. These are consumer products that often go into caulks and sealants if you're redoing your bathroom or bathroom tile work. Now, obviously these businesses are, how should I say this, contracting, right? This is kind of the consumer and housing-related construction components of the business, but the rest of the portfolio is growing considerably. They're growing organically 3% this year when 70, 65% of the overall franchise is tied to industrial and commercial construction. And they've got a lot of solutions that help companies maximize their dollar and reinvest in their business to perhaps in some cases stave off larger CapEx investments. But also they're increasingly exposed to data center, distribution center buildout. They've got turnkey solutions. They've found ways to leverage key brands in the industrial environment to bring a more comprehensive solution. So there's a lot of cross-selling going on. And from our perspective, if they're growing mid-single digits in a pretty weak industrial backdrop, any real recovery, albeit housing or more on the industrial macro, should be a considerable tailwind. And the story, for our opinion, is not really reflecting much of that. So I think you have the growth already at the low end of the cycle, and it's— the operating leverage should improve through the year, and you should see more of that hit the earnings. And I think that'll all bode very well for the stock.

Okay, so that's two. Is there one more stock that you can recommend for us in your coverage?

Yeah, and you know, when I— depends, I guess, on the way you want to look at things, but, you know, we were having a lot of conversations about this company, Axalta. It's another company you'd probably never heard of, but they paint a vast majority of new cars on the market. And if they have a big auto refinish business, so if you've crashed your car, got dings, and et cetera, you'll take it to an auto body shop and there's a very good chance you're going to be using Axalta paint. It's a highly fragmented market, particularly on the refinish side, great pricing power, but the business is under some cyclical pressure because people are feeling pretty tight at the wallet, right? Insurance premiums are up. People don't want to necessarily turn their car in to get that paint job in the current market, either because their own wallets are stretched or because insurance premiums and the clauses that might create additional costs down the line, but it's creating a fairly big backlog of work to be done. And we know that this is more a destocking cycle than it is anything fundamentally changing with the way that we are driving. Now, the market's concern, as always, is, you know, over time with autonomous driving, we're gonna get into fewer accidents, which means maybe less demand. And it's something that we watch for sure, but we don't think that's what's at play here, particularly just given The average age of the US car park is in excess of 10 years. So when you think about active driver assist, it's really small portion of the number of vehicles that are really out there. So from our perspective, it's under pressure right now cyclically, but it's as cheap as it's ever been. If you can wait it out, which most investors aren't investing every 2 weeks, you have a little time horizon. It's a phenomenal business. We're pretty sure they're gonna initiate a dividend. They have a clean balance sheet. They should be deploying capital. There's ways for reinvestment to actually kick earnings into this, and it's trading at a free cash flow yield almost at 10%, which is pretty unheard of for a business of this quality. So it's maybe more of a sleeper, but you know, from a value play in a very high quality management team and business. It's a unique opportunity, I should say.

These 3 companies sound like what you might characterize as downstream. I get my stream directions mixed up.

I gotta think about it.

You're right.

Yeah, you got it.

If we can generalize now by saying that, that you're in favor of staying more downstream than upstream, if I have that right, what's the condition or the sign that you would need to see change where you would feel more comfortable recommending that investors start to venture more upstream again?

Yeah, I mean, I'd want to get to the other side of what we expect to be some dividend cuts over the next few months. A lot of these stocks are pretty highly correlated, so, you know, even if the company that is not cutting it still could trade down considerably in sympathy, but China needs to just take a more serious view on the profitability of its own construction cycle and there's signs that this is happening, but at the same time, there's still a number of projects on the market for 2028 that don't really have steel in the ground. There's an opportunity for them to perhaps make good on this discussion they're having about taking a more holistic approach to manufacturing and manufacturing profitability and slowing down or canceling a lot of these expansions would pull forward what we consider to be the trough. If you want to invest in a cyclical stock, you kind of need to be able to capitalize or know when things are the worst and have line of sight to when they'll be better. That's how you get confidence. And right now it's really hard to kind of picture an environment that you can capitalize and want to own for the time being. People need better line of sight. The demand for this stuff will come as long as consumer keeps growing, which we think it should and has over time.

One last question for you. You've been generous with your time and I appreciate it. I always like to take the opportunity to ask a farm question when I can. You cover agricultural chemicals. I gather that farmer incomes are not riding high right now, that there's been some displacement there because of tariffs, and that affects these chemicals that are used to supply nitrogen for corn and, and the other crops and things like that. So if some of this is coming from policymakers, How do you go about trying to figure out when farmers are gonna see better conditions? It must be a really tough thing to forecast right now.

Farming has always been a very cyclical business. You have good years, you have bad years, you have floods, you have drought, you have good profits, you have bad profits. The problem for the farmer more recently has been input inflation. You know, if we look since COVID the cost of seeds to a farmer is up 25%. We have fertilizers this year up 30 to 40%. The price of a combine, I mean, I don't cover John Deere, but I know conceptually, directionally is up considerably. And farmer profits are down. Prices for corn are lower. Prices for soybeans are lower. I know there's a lot of press around the trade war with China, and obviously it would be better if they were buying our soybeans than not, but we're also contending against a very good harvest in Brazil and rising grain put from Ukraine. So it's just a tougher market in general. The problem is they haven't really gotten relief on any specific avenues. We expect fertilizer prices to fall next year. That will be helpful. Whether they fall enough, we'll see. Seed prices, not really expected to fall. They don't typically. The companies there continue to deliver value to their farmers and they tend to price for it. So it's hard, and I can appreciate certainly the concern for the farmer, because it is an entirely different ballgame from even 5 years ago as it relates to some of these input costs. There's only so much you can really do. I mean, the US already supports farmers pretty well through ethanol mandates. We have countervailing duties and tariffs on fertilizers. An easy solution would be to remove some of those. That would reduce the cost domestically for the farmer who's purchasing a lot of this fertilizer from overseas. So there's incremental things we can do, but sure, a trade agreement with China and more global demand for our product would certainly help as well. But it's not an easy fix for sure. Labor is probably more challenged incrementally given what we've seen from an immigration standpoint. And so it's just kind of a confluence of things hitting them.

Thank you, Matthew. So the answer to the question of why are some chemical stocks doing so poorly even while the overall stock market is doing so well? Is because many of those stocks are tied to the industrial economy and housing, which isn't doing so well at the moment. Also, for some of these companies, there are big oversupply issues. That's because China has added a lot of new capacity. And as Matthew told us, China has a record sometimes of caring more about job creation than profits in these industries. So you have to think that problem might not clear right away. That's a good reason, as Matthew explained, to be cautious about the upstream companies companies, but there are still some good opportunities downstream in the companies with higher margin products. That's enough for us. You can, what, subscribe to the podcast? You can send us a question. If you have a question that you'd like maybe played and answered on a future podcast episode, we'll see. So email it to me, make a recording, voice recording on your phone. Oh boy. How does it go, Alexis?

Send it to jack.hough@barons.com. We may play your recording on a future episode.

We'd love to hear it. Right. That's what I meant to say. Thanks for listening and see you next week.

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