The companies that make up the Chemical/Diversified group are largely intermediate producers of a broad array of chemicals and industrial gases. Their products are mostly used as raw materials by manufacturing industries. Major end markets served include automotive (plastics, paints), residential (carpets, fixtures, furniture) and commercial construction (glass, metals, wood), agriculture (fertilizers, herbicides, and pesticides), commercial aerospace (carbon fiber composites), and general manufacturing customers. Chemical/Diversified stocks are more commonly characterized as growth-and-income holdings, and are generally suited to investors seeking broad exposure to the manufacturing sector of the economy.

Main Categories

The products made by these companies fall into three main categories. Basic Chemicals have commodity-like characteristics and are sold in large volumes. These include petrochemicals, such as polymers used to make plastics and other man-made fibers. The category also includes such derivatives as carbon black and synthetic rubbers. Specialty Chemicals are more performance critical, value-added products, usually made to customer specifications. These include industrial gases, coatings, and chemicals used in electronics manufacturing. Finally, the Life Sciences segment encompasses animal health, crop protection, biotechnology, and pharmaceutical-related products.

Key Indicators

End markets supplied by this group typically face a wide range of economic prospects. Nonetheless, serving a variety of customers and geographic regions usually provides some downside protection in the form of diversified income streams. In general, though, basic chemicals have less pricing power during downturns, making specialty and life sciences products more stable in terms of profitability. Still, overall economic conditions play a large role. As such, the group's performance will largely mirror that of the broader manufacturing economy. In that regard, the Institute for Supply Management's Purchasing Managers Index (PMI) can be a useful guide. This index is designed to indicate whether the manufacturing sector as a whole is expanding (over 50) or contracting (below 50).

Input costs are also key. Indeed, companies in this group consume large amounts of natural gas and oil, which are mostly used as feedstock. Naturally, lower input costs translate into higher margins, and vice versa. However, it's the volatility in the pricing of these two commodities that warrants more careful attention from an investment prospective, as changes are quickly reflected on the bottom line. As a result, most of these companies employ some degree of hedging to smooth out rapid price moves. Oil and natural gas prices are less of an issue for those supplying industrial gases, where the primary concern relates to the utilization of production capacity.

Growth Via Globalization

The domestic market for chemicals is largely mature. Namely, the sizable automotive and housing sectors, through the economic cycle, post very modest average annual growth. The same is also true for the food industry (plastic bottles, agricultural products). By comparison, developing countries, most notably China and India, hold huge potential for rapid expansion in nearly all sectors.

The majority of the companies in this group have long been capitalizing on the opportunities presented by this trend, and have steadily diversified operations, building far flung production facilities. Whereas a couple of decades ago, overseas business accounted for a relatively small portion of sales, that figure has grown substantially, now accounting for 60% or more of total revenue.

In addition to the promise of high growth potential, building an international presence helps reduce exposure to economic downturns in any one region. Geographic diversification has also often resulted in a reduction of the overall corporate tax burden, because overseas jurisdictions usually have lower rates than those of the U.S. One of the potential drawbacks to this strategy, however, is increased currency risk. Reported overseas sales can boost results when the U.S. dollar weakens. But the opposite holds true if the dollar strengthens.  Meanwhile, for many of these companies, international transportation costs are prohibitive (most notably for industrial gases), requiring them to make their products where they are to be sold. This also provides a natural hedge, in that production costs are priced in local currencies.

High Capital Requirements

Most of Chemical/Diversified companies are capital intensive, reflecting the large manufacturing facilities required to produce bulk quantities. Combined with the high technology requirements, this gives the industry a competitive advantage in terms of high barriers to entry.

Because the industry operates with such high fixed costs, modest changes in sales can lead to wide swings in net income. During periods of strong demand, these costs may be spread over a larger sales base. As such, it's important to keep an eye on capacity utilization rates. Often, during economic downturns, when capacity usage is low, pricing power becomes more limited and operating margins suffer.

Continuous capital investment is necessary to upgrade or replace existing facilities. Periods of stepped-up spending-to expand capacity or increase efficiency-often raise debt burdens and restrain free cash flow improvement. Investors should be aware of what, if any, major projects are in the offing.