An Investor's Guide to the Materials Sector

By Nicole Seghetti | September 19, 2012

This month at The Motley Fool we're committing ourselves to getting back to basics, culminating on September 25 with Worldwide Invest Better Day. With this in mind, my Foolish colleagues and I are opening the floodgates and unleashing vital information to help you invest better. In a previous article, we reviewed stock diversification, a key fundamental of investing. We're taking a look at stock sectors one by one, focusing today on materials.

Elementary, my dear investor

The materials sector includes companies involved in the discovery, production, and processing of raw and synthetic materials like gold, plastics, and steel. Materials companies produce the chemicals, containers, and packaging we use daily -- the plastic in our toothpaste tubes, the copper in our plumbing, and the aluminum in our beer cans are all thanks to this sector.

How the sector performs

As a whole, the sector is considered cyclical, meaning there's less demand for materials goods in a down economy. Generally, the sector sees a boost when the economy shifts from recession to recovery. But, because the sector is so diverse and pervasive, some subsectors have their own cycles. For example, companies that make cans like Alcoa have defensive properties. Meanwhile, demand for products from chemical and agriculture companies like Dow Chemical (NYSE - DOW), Archer Daniels Midland (NYSE - ADM), and Monsanto (NYSE - MON) can change due to weather and demand from developing nations.

Over long spans of time, the sector usually outperforms. During the past decade, the materials sector returned 150% versus 105% for the S&P 500. During a weak economy, the sector usually underperforms slightly. From October 2007 to March 2009, the sector lost roughly 56%, a time when the S&P 500 lost 54%. In the most recent stock market run-up, which commenced March 2009 and is still going, the materials sector returned 130% versus 133% for the S&P 500.

Trends in the materials sector

With the growing middle class in emerging nations like China and India, the world demand for food is increasing. As these developing countries have become wealthier, diets are improving and incorporating more protein like beef and chicken. This is driving agricultural demand, fueling growth for companies like Monsanto and DuPont.

Another driver of agriculture demand is the boom in biofuels. The rising costs of fossil fuels are leading the search for alternative fuel sources, such as ethanol made from corn. Currently, 40% of America's corn crop is used to make fuel for cars. The nation's top ethanol producers, Archer Daniels Midland and privately held POET, are in a good position to benefit from this trend.

With the increased use of gold as a reserve currency, central banks became net buyers of gold in 2010 and boosted global demand to an all-time high last year. This trend is expected to continue, and companies that mine gold, like Newmont Mining and Freeport-McMoRan Copper and Gold (NYSE - FCX) with their 99 million and 34 million ounces of gold reserves, respectively, are literally sitting on heaps of it. Economic stimulus plans and infrastructure booms give these stocks a shiny luster.

Infrastructure build-out in emerging market nations is also increasing demand for metallurgical coal. Consequently, one of the world's largest iron ore producers Cliffs Natural Resources (NYSE - CLF) may enjoy a big boost to its bottom line. The Ohio-based company offers another enticing nugget for investors in its healthy 5%-plus dividend.

A quick and easy way to own the sector

Using the MSCI World Sector Weightings as a benchmark, roughly 5% of your overall stock portfolio should be allocated to the materials sector. If you're looking for an easy way to own the sector, consider a sector-specific exchange-traded fund, or ETF. Sector-specific ETFs like the Materials Select Sector SPDR ETF are helpful when you desire a quick solution.

Invest better

If you bet wrong in the stock market, it could cost you dearly. Instead, develop a diversified strategy for adding all sectors to your portfolio. That way, regardless of what happens in the market, you'll sleep well at night knowing a portion of your portfolio will prevail.