For most of the past year or so, the Basic Materials sector has offered some of the most interesting cases for value-based investing.
The idea of finding useful “targets of opportunity” when the broad market is highly uncertain is one of the reasons I like to put so much emphasis not only on a stock’s valuation but also on its fundamental strength. The market’s momentum can and will effect every stock at some point, no matter what my fundamental and value metrics may say about what a stock’s price could be; but if a stock’s drop is coming from market momentum while solid fundamentals remain in place, the value proposition should get even more compelling. Eventually, the market is going to recognize that discount as well, and when it does, it will push the stock back up again. The folks that will be best positioned to take advantage of that bullish reversal won’t be the ones that tried to time the reversal, but those that recognized the value proposition during the drop and weren’t afraid to start buying while it was there.
The Basic Materials sector is made up of industries, and companies that transform raw materials and chemicals into the components and goods that other industries use to create and produce the finished products that businesses and consumers use. That’s why I really like the sector as a barometer for broad economic conditions. The fact is that many of these companies produce goods that are needed and continue to see demand even during difficult economic times, which also makes the sector an interesting one to think about using when everybody else is running away from the market as fast as they can.
The smartest companies in this sector recognize the that exposure to the variability of costs in raw materials and commodities injects in their business and actively consider ways to minimize and manage those variances on a long-term basis. I think the intelligence many of these management teams have about how to run their business in every economic condition is just more reason that there are useful opportunities that can be found in this sector right now if you’re willing to take the time to dig into them.
Dow Inc. (DOW) is a stock that has only been traded publicly for a few years, but is also a company with a long history behind it. Its primary subsidiary, Dow Chemical, is one of the three largest chemical producers on the planet. When DOW was spun off of its then parent company, DowDupont in 2019, the new company was immediately added to the Dow Jones Industrial Average. Even with the difficulties that have been associated with global conditions over the past three and a half years, this is a company that has leveraged its position as a market leader, along with its economies of scale, to manage a lot of the raw materials cost risks have weighed on the industry this year. They also boast healthy free cash flow, a generally solid balance sheet, and a very attractive dividend. From a February peak at around $61, the stock dropped to a low point in late May at around $48.50. It’s picked up a lot of bullish momentum from that point, driving to its current price at around $56 since then, with a lot of that momentum coming in the last week, in the wake of the company’s latest earnings announcement. Are the company’s fundamentals strong enough to support that rally, and to suggest it should continue? Let’s dive in.
Fundamental and Value Profile
Dow Inc. is a holding company for The Dow Chemical Company and its subsidiaries (TDCC). The Company’s portfolio of plastics, industrial intermediates, coatings and silicones businesses delivers a range of science-based products and solutions for its customers in various market segments, such as packaging, infrastructure, mobility and consumer care. The Company’s portfolio is comprised of six global business units, which are organized into three operating segments: Packaging & Specialty Plastics, Industrial Intermediates & Infrastructure and Performance Materials & Coatings. Packaging & Specialty Plastics consists of two global businesses: Hydrocarbons & Energy and Packaging and Specialty Plastics. Industrial Intermediates & Infrastructure consists of two customer-centric businesses: Industrial Solutions and Polyurethanes & Construction Chemicals. Performance Materials & Coatings includes two global businesses: Coatings & Performance Monomers and Consumer Solutions. DOW has a current market cap of about $40.9 billion.
Earnings and Sales Growth: Over the last twelve months, earnings declined by -67.5%, while revenues shrank a little more than -27%. In the last quarter, earnings were 29.3% higher, while sales growth declined by about -3.6%. The company’s margin profile is stable, and improving, with Net Income that was 3.54% of Revenues over the last twelve months, and 4.25% in the last quarter.
Free Cash Flow: DOW’s free cash flow is healthy, but has declined steadily of the past year. It was about $3.7 billion in the last quarter versus a little over $4.3 billion in the quarter prior, and almost $5.5 billion a year ago. Despite the decline, the current number translates to a useful Free Cash Flow Yield of 9.51%.
Debt to Equity: DOW’s debt/equity ratio is .72. This is generally a low number that indicates management takes a conservative approach to leverage. Their balance sheet shows $2.9 billion in cash and liquid assets (down from $3.3 billion in the quarter prior) versus about $14.7 billion in long-term debt.
Dividend: DOW’s annual divided is $2.80 per share, which translates to a yield of 5.05% at the stock’s current price. It is worth noting that the company’s dividend has been consistent at this level since its spinoff from DowDupont, and did not change in 2020 when many companies throughout the marketplace were slashing or eliminating their dividends altogether.
Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but I like to worth with a combination of Price/Book and Price/Cash Flow analysis. The fact that this company has existed as a publicly traded entity for less than three years provides a limited historical sample to work with, so I have also incorporated the company’s PEG ratio, which adds estimates for the company’s future growth to the mix. All together, these measurements provide a long-term target at about $53 per share. That suggests that even that the stock a bit overvalued, with -4% downside from its current price, and a practical discount price at around $42.50.
Technical Profile
Here’s a look at the stock’s latest technical chart.
Current Price Action/Trends and Pivots: The red diagonal line traces the stock’s upward trend from its low in October of last year at around $43 to its high, reached in February at around $61. It also provides the baseline for the Fibonacci retracement lines shown on the right side of the chart. The stock hit its latest, major pivot low at the end of May at around $48.50. That provided a springboard for the stock’s run upward from that point, with the latest surge pushing the stock out of a narrow consolidation range after the stock’s latest earnings announcement. Current support is around $54, which coincides both with the top of that consolidation range as well as the 38.2% retracement line, with immediate resistance expected at around $57, based on a pivot high in mid-April, along with pivot low activity in January and February at that level. A push above $57 could see the stock pick up enough bullish momentum to retest its 52-week high at around $61, while a drop below $54 should find next support at around $52.50, which marked the lower end of the stock’s recent consolidation range.
Near-term Keys: I think DOW’s fundamental profile in the face of the past three year’s worth of difficult economic conditions is an interesting story, however those pressures, along with the stock’s latest rally, have pushed the stock past the point of useful value. That means that the best opportunities to work with this stock lie in short-term trading strategies. A push above $57 could be a good signal to think about buying the stock or working with call options, with a useful profit target at around $61. A drop below $54 could see downside to about $52.50 before finding next support, which could provide an opportunity to think about shorting the stock or buying put options with a quick exit target.