With previous experience in chemical engineering, Senior Equity Analyst, Mike Kijesky CFA is well equipped to evaluate the complex issues facing the basic materials companies. Mike puts his analytical skills to use identifying attractive investment opportunities for Adams Funds. In this interview, he discusses his current view on the rapidly changing dynamics in this sector.

Specifically, we’re looking in certain subsectors with growth potential such as agricultural.

Michael Kijesky

Q
The materials sector is diverse and economically sensitive. Although, global growth has slowed, particularly in emerging markets, Adams Funds investments have performed well. How are the Funds currently positioned?
A
In this slow-growth economic environment, our focus has been on companies with differentiated products and clear cost advantages over their competitors. We have limited our investments in companies and industries that require robust growth from the global economy to be successful. This has led us to favor agricultural-levered companies and U.S.-focused petrochemical companies, while limiting our exposure to industries such as industrial metals and mining.
Q
In looking at the portfolio, the Funds are invested heaviest in chemicals. What are the drivers for that decision?
A
Many U.S.-based petrochemical companies are able to take advantage of the shale oil boom in the energy industry. Because of the prolific production growth in oil and gas shales around the country, U.S. chemical companies have a structural feedstock cost advantage over their competitors in Europe and Asia. A great example of this is LyondellBasell (NYSE Ticker: "LYB"), whose shares we currently own. They are able to convert components of natural gas liquids produced from U.S. shale into monomers like ethylene and propylene, at a fraction of the European and Asian costs. These products are key components in manufacturing plastics and many other specialty products. This cost advantage provides greater profits and opportunities to export value-added products.
Q
You mentioned the agricultural industry as offering growth opportunities. Can you discuss the market dynamics in agriculture?
A

This is one area where we've witnessed strong demand from a growing global population and an expanding middle class in emerging markets. As the population grows in these regions and people become more prosperous, we're seeing an adoption of a more protein-intensive diet. At the same time, land for food production is at a premium, so the companies that can provide farmers with inputs to increase the production of their fields have been and will continue to be rewarded. Fertilizer manufacturers, for instance, have been an area of focus for us and the Funds have benefited.

I'll provide an example. Nitrogen fertilizer has been the biggest beneficiary of the global need to increase yields for row crops. CF Industries, a portfolio holding, is well-positioned as a global nitrogen producer. They have the most extensive production and delivery system in North America and are the only pure play beneficiary of the arbitrage between higher-cost nitrogen fertilizer imports and low-cost domestic production. This is driven by cheap methane prices in the U.S. and Canada relative to the other major global producers/exporters.

Q
The Funds have benefited by avoiding investments in some subsectors. Where have you limited exposure and why?
A
As I mentioned earlier, we limited our exposure to metals and mining. In general, these companies have very high fixed costs and need to run their facilities at high utilization rates to be successful. In slow-growth economic periods, capacity tends to grow as fast as or faster than demand, keeping utilization rates below the required thresholds. When economic conditions are sufficient to generate demand that exceeds supply, the large operating leverage inherent in these businesses can create some excellent investment opportunities. We have not seen those conditions in a while, however, and therefore have limited our exposure to the group.
Q
What are the major challenges companies in the sector are facing?
A

The materials sector is marked by changing supply/demand dynamics. Commodity pricing is currently in the weaker part of the cycle. Following a few years of robust demand, the industry overbuilt just as growth in emerging markets has subsided -- most notably, the slowdown in China is having a considerable impact. Globally, slow worldwide economic growth and low capacity utilization continue to be headwinds for the sector.

While much of the sector relies on a healthy global manufacturing economy for its success, investment opportunities can be found. Specifically, we're looking in certain subsectors with growth potential such as agricultural. Additionally, companies that experience margin expansion from lower commodity costs, or have cost advantages compared with foreign producers, will continue to appeal to us as potential investments for our Funds.