Spot the Next Outbreak of Material Madness

Look beyond the usual large-cap suspects to find great new ideas in the basic-materials sector.
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Over the last few weeks we have watched the scrolling ticker tape in amazement as the

Materials Select Sector SPDR

(XLB) - Get Report


Vanguard Materials ETF

(VAW) - Get Report

have taken off to new highs. So far this year, these sector ETFs returned 7.4% and 8.3% respectively.

The top five stocks in these two ETFs include a who's-who of large-cap diversified chemicals and metals. These highly rated stocks include

E.I. du Pont de Nemours

(DD) - Get Report


Dow Chemical

(DOW) - Get Report



(AA) - Get Report





Phelps Dodge

(PD) - Get Report


Now, there is nothing wrong with investing in this quintet of large-cap materials stocks. Our quantitative model loves the excess cash these companies are generating and their collective recent spurt of top-line growth. They are all rated buy, and they give you exposure to basic materials.

But where are the next stocks in this sector that might drive investors into a mad buying frenzy and generate real excitement?

Looking closer into the materials sector, we came up with three smaller, less recognized names that look to be excellent options to consider. Note that our definition of "smaller" is relative to the sector.

The average market capitalization of these next three companies is $9 billion, compared with $36 billion for the large-cap materials stocks. The other surprise is that being smaller gives companies' management the opportunity to focus on fewer areas and be leading players in their niches.

The first name is

Titanium Metals


, a $5.6 billion market-cap diversified metals and mining company. The company is commonly referred to as Timet.

It operates as a vertically integrated manufacturer of titanium products, melted products (ingot and slab) and mill products. These products are used in the aerospace business, with 65% of last year's sales coming from the U.S. and 35% from Europe.

While the stock is in the materials sector, this is really a play on the aerospace and defense business. Those who follow Timet closely also monitor Boeing and Airbus aircraft-build projections, the periodical

Airline Monitor

and other indicators. With its specialty focus, Timet has been able to post compound revenue growth of 45% over the last three years and produced solid return on equity last year of 27%

What's driving all this demand? In addition to aerospace's demand for titanium, the power-generation, chemical-processing and desalination markets are recovering from recent lows and struggling to meet current demand.

The earnings outlook for Timet is strong, with a sales order backlog at the end of 2006 at $1.1 billion and with earnings-per-share growth forecast at 34% to $2.21.

This has not gone completely unnoticed; total return to shareholders over the last 12 months reached 77%. But this one still has very attractive defensive valuation characteristics, selling at just 15 times next year's consensus earnings estimate.

The stock still looks cheap, selling at a price-to-forward-earnings ratio that is half of the projected earnings growth rate. This low P/E ratio is just what you want to see when you look into prospective investments in cyclical stocks.

The second selection is

Allegheny Technologies

(ATI) - Get Report

. This $10 billion market-cap steel company also produces specialty materials including super stainless steel, nickel and titanium alloys. Last year, about 75% of sales came from the U.S. and 25% from a variety of international regions.

For next year, the earnings outlook is also very positive for ATI, with an $8.23 consensus earnings estimate for 2008. The stock set a new high in January when Allegheny announced that it had signed a long-term sourcing agreement with GE Aviation for the supply of premium titanium, nickel-based superalloy and vacuum-melted specialty alloy products for commercial and military jet engine applications. The total revenue of this agreement plus direct sales to GE Aviation for the period of 2007 through 2011 may exceed $2 billion.

The stock sells at an attractive 12.4 times forward earnings.

For those who can't get enough of titanium stocks, our model also points to the smaller $2 billion market cap

RTI International Metals


as being attractive.

But for our third selection,

Vulcan Materials

(VMC) - Get Report

, we are picking something more basic and defensive in nature. Vulcan produces, distributes and sells construction materials, including construction aggregates, asphalt and ready-mixed concrete.

As the largest U.S. producer of construction materials, this $11.1 billion market-cap stock was up 58% over the last 12 months. By reinvesting in growth and utilizing a more efficient capital structure, this high-cash-flow business should outperform industry peers and the overall market.

Organic growth comes from the public works, highway and nonresidential construction end markets, all of which have been growing more rapidly than the overall economy. Geographically, Vulcan is positioned to serve Georgia, Florida, Texas and California markets, which are growing faster than the rest of the U.S.

For example, California voters approved the funding of $43 billion of infrastructure bonds that should eventually emerge as tangible projects utilizing Vulcan aggregates.

The company continues to add material reserves via acquisitions and is a beneficiary of the ongoing consolidation trend in this business. The top 10 producers of aggregates account for only one-third of overall production. On Feb. 19, Vulcan announced that it will buy

Florida Rock Industries


for $4.6 billion.

This deal increases Vulcan's reserves to about 45 years of production and reinforces its critical mass in Florida and the East Coast. While the deal does not change earnings guidance, over the next three years the $2 billion of projected cash-flow generation should help the company pay down the debt it will take on as part of the deal.

The net effect is a rock solid company that should reward shareholders. Year over year, Vulcan has rewarded shareholders with a 56% total return.

Real basic values.

Rudy Martin is the director of research for Ratings. In keeping with TSC's Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

In keeping with TSC's Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Martin cannot provide investment advice or recommendations, he appreciates your feedback;

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