Recovery May Spark a Nice Chemical Reaction

Chemicals might not be very sexy, but they sure proved to be the right formula for making investors decent money in the past few months.

Much like the other economically sensitive sectors I've written about since last fall -- namely industrials and paper stocks -- chemicals have tremendously outperformed the market. Year to date, the Dow Jones Chemicals index is up 8.4%, well ahead of the S&P 500, which is essentially flat. Since the market's September low, chemicals have soared nearly 37%, while the S&P 500 has gained 19%.

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Two stocks I highlighted, Dow Chemical (DOW - commentary - Cramer's Take) and Rohm & Haas (ROH - commentary - Cramer's Take), have turned in mixed results. While Rohm & Haas surged 23% in a little over a month, Dow shares are off about 9%, although up 41% from the asbestos-induced panic that drove the shares below $24 in January. (I noted then that people would look back at that as an incredible buying opportunity.)

Early to Rise

The early birds to this sector and to cyclicals in general have swallowed the worm, and the stocks now largely reflect good news to come on the economic front. Even so, it may be too soon to consider dumping them.

We're still at an early stage in the economic recovery. Although chemical stocks have made a strong move in a short period of time, they're still nowhere near the levels they'd be at if they were being valued on an earnings peak. I wouldn't be surprised to see a pause in the action until earnings confirm the improved economic outlook.

But in a few months, investors may start factoring in expectations for continued growth in 2003 and beyond, and that could send the stocks to higher levels. The chart below tracks the valuation on major chemical stocks as measured by enterprise value (market value of equity plus net debt) to sales ratio, going back to 1980. According to Morgan Stanley, the group now sells at about 1.2 times sales, about where it was when we were coming out of the last recession 10 years ago. It wasn't until late 1994 that the valuation topped out at about 1.5 times sales.

Chemicals Could Still Move Higher Valuation based on enterprise-value-to-sales ratio

Source: Morgan Stanley

Nevertheless, I'd pick my spots in chemical stocks carefully. The iShares Dow Jones U.S. Chemicals Index fund (IYD - commentary - Cramer's Take), an exchange-traded fund that is completely invested in chemical stocks and tracks the Dow Jones index of the same name, is one way to play the sector on both the long and short sides. As I noted earlier, the Dow Jones Chemical index is up more than 8% year to date.

Getting Into Specifics

At its current price near $40, Rohm & Haas is no bargain. It's now trading at a price-to-earnings ratio of 19 times 2003 estimates, an enterprise-value-to-sales ratio of 1.82, and enterprise-value-to-EBITDA ratio of 8.3, according to Morgan Stanley estimates. Compare that with its 10-year average P/E of 14 and average EV/EBITDA of 8.3.

Although I think Rohm & Haas has double-digit earnings growth potential in the long term because of technology exposure from its electronic materials business, its shares are now trading above their historical average valuation range. I wouldn't chase them here.

Similarly, DuPont (DD - commentary - Cramer's Take) is also looking pricey, trading at roughly $48. Its stock trades at a P/E ratio of almost 20 on 2003 earnings estimates, an EV/sales ratio of 2.0 and an EV/EBITDA ratio of 13.3 -- also above its historical average.

But again, the stock could do well on better-than-expected news from the auto, textile and housing industries, where DuPont derives about 40% of its sales. General Motors (GM - commentary - Cramer's Take), for example, just raised its expectations for both production and earnings for this year, so we'll see if the trend continues.

Dow Chemical, on the other hand, is still relatively cheap at $32 -- if you can stomach the potential volatility from news on asbestos settlements. I continue to believe that Dow's ultimate asbestos exposure will have little meaningful impact on the company's earnings. Don Carson, chemical analyst at Merrill Lynch, values Dow's future uninsured asbestos exposure at just $1 to $3 pretax per Dow share. But the market could easily punish the stock more than that, as we have seen.

Even so, the valuation is hard to pass up. Dow shares are trading at a P/E ratio of 13 on 2003 estimates, an EV/sales ratio of just 1.2 and an EV/EBITDA ratio of 6.5, according to Morgan Stanley estimates. These are well below both the chemical group overall and Dow's historical average. Plus, the shares yield a very decent 4%.

Dow is the industry bellwether, with exposure to all phases of economic recovery -- both in the near term through its chlor alkalai and polystyrene businesses, which are exposed to construction, appliances and electronics, as well as in the longer term, when its ethylene business, which is suffering from overcapacity, should stage a rebound.

Some analysts put Dow's earnings potential several years out as high as $7 per share. (Per-share estimates for 2003 come in now at $2.46.) I think that's worth the risk.

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Odette Galli writes regularly for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to Odette Galli.