The basic-materials sector is one of the most overlooked sectors in the world. If you’re like most people, you think about investing in sectors like technology, services, and medicine. However, many investors rarely think about the companies that mine the metals used in memory chips, provide the fabrics used on airplane seats, or produce the chemicals in the world’s most effective medicines.
Everything you buy, whether it be a product or service, involves the use of at least one basic material. Even telemarketers couldn’t work without the plastic and metal used to create the phones and computers in their offices.
So, as you would imagine, the basic-materials sector is one that holds quite a bit of value. With products that the world simply can’t live without, some of the companies in this sector are massive profit machines.
With the profits being generated from the production and sale of basic materials around the world, it only makes sense that investors want to get involved. But, before you dive into basic-materials stocks, it’s important that you understand what the sector is and what makes companies within the sector tick.
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What Are Basic-Materials Stocks?
Basic-materials stocks represent companies that work within the basic-materials sector. So, what are basic materials?
Basic materials are the materials used to make just about everything. They are the raw materials that you find in metals, building materials, plastics, and jewelry. Some of the most widely recognized basic materials include:
- Precious Metals. Gold, silver, and platinum are all forms of precious metals. These metals carry a high value because they are rare and expensive to mine. As a result, they are often used in the development of jewelry.
- Oil. Oil is the basic material that drives the energy sector. Oil is refined to create products like gasoline, diesel fuel, and jet fuel, among a long list of other fuels and products.
- Wood. The wood that was used to build your home, kitchen table, and frame for your couch is a basic material as well.
- Iron Ore. Iron ore is an essential raw material used in the production of steel, which in turn is used to build the high-rise buildings that grab your attention in the city as well as some of the components that keep your car’s engine running.
- Raw Chemicals. Raw chemicals are used in the production of medicine, cleaning supplies, and other products necessary for day-to-day life in a developed nation.
The vast majority of basic materials are naturally occurring materials. However, some basic materials, including some chemicals found in medicines, perfumes, and cleaning supplies, are human-made. Regardless of whether a basic material is synthetic or natural, what defines it is its role as one of the most basic, most raw, materials found in day-to-day products.
Basic materials, even natural ones, are produced in different ways. Some are reusable or renewable, offering companies the ability to produce, use and sell, them over and over again. Wood is a great example of a renewable raw material.
On the other hand, some basic materials are finite. This means that it takes thousands or even millions of years for these materials to develop. Finite basic materials make up the vast majority of the basic-materials market, including oil, precious metals, stone, and other building materials.
Is It a Basic-Materials Company?
The basic-materials sector is often confusing for newcomers. In particular, deciding if a stock is a basic-materials stock or one that lives in another sector can be difficult.
Just because a company works with a basic material does not mean that the company is a basic-materials company. Keep in mind that basic-materials companies work in the discovery, development, and initial processing of raw materials.
Considering that description, the company that mines for gold is a basic-materials company. The company that cleans the gold and uses it to form measured, easily shippable bars is a basic-materials company. However, the jeweler that turns the gold into a necklace or the dentist who puts the gold on a patient’s teeth are not basic-materials companies.
It’s important to understand the differences between basic-materials companies and the companies that use basic materials because they will have different valuation metrics, operate in different ways, and behave in different ways in the market.
Pro tip: If you’re going to add basic materials stocks to your portfolio, make sure you choose the best possible companies. Stock screeners can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Basic-Materials Stocks Pros & Cons
Any time you make an investment, it’s important to consider the pros and cons. Because no investment comes without risk, there will always be pros and cons to any investment vehicle, and basic-materials stocks are no different. Here are the pros and cons you should consider before diving into the sector.
Pros of Basic-Materials Stocks
Basic materials are used in every product you purchase. So, naturally, there are going to be benefits involved in investing in the space. Some of the most important pros associated with an investment in the basic-materials space include:
1. There Will Always Be Demand for Basic Materials
A wide range of basic materials were used in the development of the car you drive, the house you live in, the bed you sleep on, the clothes you wear, and just about everything else around you. That’s a huge statement.
Without basic materials like wood, iron ore, and oil, life as you know it simply couldn’t exist. There’s a great strategic benefit involved in investing in companies that provide a product that is absolutely necessary for day-to-day life. It’s what makes consumer staple stocks so attractive, and it adds to the attraction investors have for basic-materials stocks.
The bottom line is that investing in materials that are vital for day-to-day life in developed nations offers a sense of security that even the most impressive tech stocks can’t match. After all, the iPhone is extremely popular today, but a new phone may make it a thing of the past. On the other hand, wood and steel will always be needed to develop homes and commercial buildings. So, these products never become obsolete.
2. Some Basic-Materials Stocks Are Cyclical
Some basic-materials stocks are cyclical in nature. Cyclical stocks ebb and flow with economic conditions. So, when economic conditions are positive, these stocks tend to see moves toward the top. Conversely, when economic conditions are negative, these stocks generate losses.
The cyclical nature of many stocks in the basic-materials sector makes them relatively simple to time. By paying attention to the nightly news, you’ll get an idea of economic conditions. When conditions are positive, it’s time to buy; if conditions are negative, it’s time to sell. Having the ability to use economic conditions to guide your investment decisions adds yet another tool to your investing toolbox, expanding your opportunity to generate profits and potentially beat the market.
Some examples of cyclical basic-materials investment opportunities include:
- Wood Companies. Companies in forestry that profit from the sale of wood ebb and flow with economic conditions as consumers are more likely to build when they are confident in the stability of the economy and their ability to pay back mortgages and other construction loans. As such, when economic conditions are positive, forestry stocks tend to gain. Conversely, when economic conditions are negative, forestry companies tend to take a dive.
- Oil Companies. When economic conditions are negative, consumers tend to travel, go out to eat, and enjoy entertainment outside of their homes less. This leads to less demand for fuel. Consumers are also likely to pay more attention to their power consumption in their homes, further impacting the oil sector. On the other hand, when economic conditions are positive, consumers drive more and are more lenient with power consumption, helping to increase the demand for oil and leading to gains in oil stocks.
- Other Building Materials. Because economic conditions impact building and land development, companies that produce materials like iron ore, steel, glass, and copper, tend to move in tandem with economic cycles.
3. Some Basic-Materials Stocks Act As Safe Havens
While some basic-materials stocks are cyclical, others fall into the category of safe havens. This means that when economic conditions are poor and investors expect declines in the overall market, they tend to pile their money into these stocks, leading to gains. On the other side of the coin, when economic conditions are positive, investors tend to ditch safe havens, leading to declines.
The best example of a safe-haven basic-materials company is a gold miner. In times of economic hardship and market turmoil, investors tend to ditch stocks in general and buy gold and silver. As a result, economic declines mean gains in the values of precious metals.
That’s great for the companies that mine these metals. The cost of mining declines during tough economic times due to a reduced cost of fuel. At the same time, the amount of money these companies can charge for their end products increases due to demand from safe-haven investors. This equates to reduced expenses, increased revenue, and, ultimately better profitability, sending these stocks upward.
During times of economic unrest, it’s always good to have a few safe-haven investment opportunities to fall back on.
Cons of Basic-Materials Stocks
Basic-materials stocks offer great perks, but even the best of the best in any category will come with its blemishes. Basic-materials stocks are no different. Here are some of the drawbacks you should consider before making an investment in the basic-materials sector:
1. Cyclical Isn’t Always Good
The vast majority of stocks in the basic-materials sector are cyclical stocks. While that’s great for some investors, for others, cyclical stocks aren’t anything they want to be involved in.
Ultimately if you’re looking for slow, steady, consistent growth with the potential to generate income through dividends, the vast majority of stocks in the basic-materials sector aren’t going to scratch your itch.
Also, while cyclical stocks make timing a bit simpler for the beginner investor, your entrance and exit timing is absolutely essential. With slow-growth dividend plays, timing isn’t as important because these stocks will generally trade flat or experience minor gains or declines during tough economic times. Conversely, because cyclical stocks can nosedive during tough economic times, making an ill-timed investment will prove to be overwhelmingly costly.
2. It’s A Boring Sector
If you watch “Shark Tank,” you’ll notice that Lori Greiner, Daymond John, Mark Cuban, and Barbara Corcoran never invest in a product that they don’t like and relate to. Kevin O’Leary and Rober Herjavec do on occasion, but it’s rare.
Why is it that the sharks don’t invest in what they don’t enjoy?
Because you have to take the time to research and understand your investment. If you invest in a category that you don’t enjoy learning about, you’re less likely to do the needed due diligence to help secure profits when you make investments.
The fact of the matter is basic materials are, well, basic. The definition of basic might as well be “boring.” Fewer investors find joy in the due diligence involved in these types of stocks than those who enjoy digging into the inner workings of “sexier” investments like Apple or Facebook.
3. Big Companies May Not Generate Profits
Mining and other activities involved in the development of basic materials is overwhelmingly expensive. The only way to make any real money in the space is to have a massive operation. This creates profitability concerns, even with some of the big players in the basic-materials space.
It’s common to see basic-materials companies with market capitalizations in the hundreds of millions or even low billions of dollars that don’t make a penny in profit. That’s not good news. Due to the overwhelmingly high cost of mining, these companies are ultimately at the mercy of the lenders and investors that fund them.
Should You Invest in Basic-Materials Stocks?
While basic-materials stocks are a great option for some investors, they’re not even worth consideration for others. An investor in the basic-materials sector should possess the following two key qualities:
- A Genuine Interest in Basic Materials. It’s best to have a genuine interest in anything you invest in. So, if you’re looking to invest in basic-materials stocks, you should have a general interest in learning about these materials and the industry that surrounds them.
- A Willingness to Keep up With Economic Conditions. Most basic-materials stocks are cyclical. Anytime you invest in cyclical stocks, it’s important to keep an eye on economic conditions for clues as to when to enter and exit positions.
How Much Should You Invest in Basic-Materials Stocks?
It’s generally not a good idea to invest 100% of your portfolio into any group of stocks. Basic-materials stocks are no different. So, how do you go about allocation while keeping diversification in mind?
When deciding how much of your portfolio you intend on investing in basic-materials stocks, ask yourself the following questions:
Are Economic Conditions Positive?
For just about all basic-materials stocks, the condition of the United States economy will play a role in their growth. In general, tough economic conditions will lead to declines in basic-materials stocks outside of the precious metals category. In these same stocks, we tend to see growth during positive economic conditions.
When it comes to basic-materials companies focused on precious metals, the exact opposite is true.
As a result, if you’re considering investments in precious-metals companies, a higher percentage of your funds should be allocated during times of economic unrest. Conversely, when economic conditions are positive, smaller percentages of your funds should be invested in the category.
In terms of all other basic-materials stocks, larger allocations should be considered during positive economic times and smaller allocations are best during an economic downturn.
What Are Your Investing Goals?
Your goals as an investor should always play a role in your allocation decisions. For example, if you’re looking for high dividends and stable growth, basic-materials stocks aren’t necessarily where you’ll find what you want. Instead, you should look toward utilities stocks.
Due to the cyclical nature of basic-materials stocks, these investments are best for someone looking to beat the market by buying on lows and selling on highs throughout the year.
Follow the 5% Rule
The 5% rule is one of the most important guidelines to follow, especially for beginner investors. The rule states that you should never invest more than 5% of your entire portfolio into a single stock and that you should never invest more than 5% of your entire portfolio into any mix of high-risk stocks.
So, if you’re looking at a relatively established company in the basic-materials sector, you can invest up to 5% of your portfolio value in that stock.
For example, let’s say you have $10,000 to invest. You think a basic-materials stock has potential, but you’re not quite 100% sure it will grow. Considering the five-percent rule, you can invest up to $500 in the stock, but you have reservations. You might invest half of your max allocation, or $250, to gain exposure but keep risk at a minimum.
High-risk stocks work a little differently. Instead of 5% per stock, you have 5% of your entire portfolio to spread among the riskier plays. So, using the same example portfolio value of $10,000, let’s say that you’re interested in four high-risk stocks. You know the risks but you want equal exposure to these seemingly impressive opportunities.
Based on the 5% rule, you can invest up to $500 across all four high-risk stocks. So, you would divide the entire $500 cap by four, investing $125 into each high-risk opportunity you’re considering.
Basic-materials stocks come with great benefits. After all, the world as you know it simply wouldn’t be the world as you know it without them.
While these stocks do provide opportunities for the right investors, it’s important to do your research and make educated decisions. Moreover, diversification is key regardless of which sector catches your eye.
Nonetheless, when you do your research, properly diversify, and make educated decisions in the basic-materials sector, great things can happen.
Do you invest in the basic-materials sector? Are you more interested in precious metals or other basic materials?