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European specialist salesman for all sectors.

      The chemicals sector

      Introduction

      Chemicals are the world’s third largest industry, with sales in excess of US$1trillion worldwide. Significant trade flows ensure that no region is exempt from global trends. It is highly diverse with dozens of sub-sectors and tens of thousands of different products.

      Chemicals are used in virtually everything, from drugs to diapers, and greatly enhance our quality of life. In western economies growth is close to GDP levels, while it can be twice GDP in industrialising markets. Growth is driven in part by the substitution of other commodities, such as glass or metals, and by the outsourcing of previously vertically integrated processes such as pharmaceutical intermediates. Each chemical has a finite life cycle, so companies need to innovate to sustain growth.

      An alternate approach to growth is to follow the demand for more mature products in new geographic locations, such as emerging markets. Asia is recovering its status as the engine of growth for global chemicals, contributing about half of total incremental demand.

      1. It’s not for junior Buffetts - be active.

      Investing in the chemicals sector has not rewarded a ‘buy and hold’ strategy. After keeping pace with equity markets worldwide in the 1960s and 1970s it began to underperform the bull markets of the 1980s and to do even less well in the 1990s. It offers tremendous profit opportunities, nonetheless, for active management. My confidence comes from a simplistic analysis of 52 week high and lows for the US and European companies for the past several years. The ranges (for just about every stock) are enormous and a canny investor can make substantial profits with astute timing.

      2. It may be mature but it’s not a sunset industry, and arguably not one sector.

      Investors often argue that chemicals represents a ‘sunset’ industry for investment. On the contrary, it is probably the most innovative of all industries, and innovation has led to the emergence of huge sub-sector industries such as high-end electronics and fuel cells. There is nothing ‘sunset’ about those.

      The issue for investors is a) how to profit from the innovation and b) how to judge whether the innovators are commercial or commercially managed. A major problem lies in the fact that the industry is regarded as one mass. There is such a range of business models, profit drivers and production requirements across the industry that it blurs investors’ focus and leads to generalizations like that about a ‘sunset industry’. Try to be ‘micro’ not ‘macro’ in your approach.

      3. “Business is other people’s money” - Mme de Girardin.

      In this case, your money is in the hands of a management team, and management is critical in this industry. Competing for investor dollars requires able managers who lead by example, encourage an entrepreneurialis spirit, and constantly renew the company to keep pace with change (both competitive and regulatory). Investors will profit by getting to know their managers and by understanding their motivation - is it the shareholder, the corporate entity, job preservation, or the route to another job? Some parts of the chemicals industry consistently let down investors: it is worth remembering the maxim that when good management is put into a bad industry it is the industry’s reputation that prevails.

      4. M&A - a route to fortune? Occasionally.

      One of the most successful ways of profiting in the chemicals industry has been to identify the ‘next most likely’ takeover candidate. But it is fraught with danger. Time works in favour of investors in quality businesses as it enhances the value of their holdings, but it may not work in favour of ‘bottom fishers’ holding stock in a lame victim which they hope will become a predator’s prey. As time passes, value erodes.

      I have watched many investors buy stocks that ‘must get bid for’ and even when that sometimes occurs, the passage of time has led to an erosion of corporate value and a bid price close to the investor’s entry price. The M&A market is changing too, with buyers more wary of buying companies and more interested in buying businesses within a company. This helps avoid the assumption of potential environmental and pension liabilities, which are increasingly acting as a constraint for dealmakers.

      5. Look beyond EPS.

      Chemicals is a capital intensive industry so it is critical not to be seduced by the apparent success of a company’s EPS growth. Across the sector lie many distortions in depreciation and taxation policies which investors need to appreciate to be able to make an informed decision.

      6. Beware the buzzwords ‘strategy’ and ‘innovation’.

      It would be disconcerting to find a company management without a coherent strategy. However, the number of strategic changes and initiatives seems to be intensifying. Having an attractive strategy is one thing, but far more important is that the management and employees are committed to the execution of the strategy.

      In sport there are many players who have a reputation for ‘talking a good game’ and far fewer who are winners. Look for the less showy, but most effective. Similarly there is a current trend to boast about a company’s innovation. Not all companies profit from innovation. Bottom line - management is key.

      7. The benefits of incest! Listen to the industry.

      The chemicals industry is a huge user of its own products. It is incestuous. Customers and suppliers are common to many companies and much can be gleaned from talking to these ‘related’ companies to ascertain the wisdom of an investment. Listen to the chatter. Anecdotal evidence is often (always?) more valuable than a well-paid analyst’s spreadsheet. Equally, listen to employees at the company which you are considering investing in. I’ve never known a company where unhappy people are more productive than happy ones.

      If possible it’s worth getting to know the employees below board level - do they share the company’s aspirations, and are they happy with the way they are treated and remunerated? If not, the strategy has no chance of being executed, the best people will leave for the competition, and the cost of replacing them will soar because of the company’s reputation as a poor employer.

      8. “Never is there just one cockroach in the kitchen.”

      This quote, from Warren Buffet, is especially apt in a sector that has a long list of relative (to the wider equity market) underperformers and apparently cheap stocks. My interpretation is that a bad business is likely to remain a bad business and investors should avoid the “it cannot get any worse” school of bargain hunting. Experience has taught me that bad/cheap stocks get cheaper, and cheaper for a reason.

      9. Think global.

      Chemicals is a global industry, so avoid making comparisons with local (just European or just US) companies. It is fiercely competitive, and production, supply and customer dynamics are constantly evolving. This is not necessarily a negative - think about a company’s ability to transfer production around the globe, and whether it is critical to be near customers, and whether or not a customer industry (eg. textiles) is migrating to a new region.

      10. Watch the costs.

      Many companies are making a virtue of reducing capital intensity by moving to more specialty applications. What is rarely mentioned is that these lower volume, higher priced, products require a much higher research spend, technical support and marketing budget. Just because a specialty company redefines its costs does not mean that these are not the costs of staying in business.

      11. Don’t wait for the ‘right’ price.

      The whole point of buying a stock

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