Are Metals and Materials Stocks a Buy?

For most investors, maintaining a diversified portfolio is a good way to help minimize risk and sleep better at night while also making sure you don't miss out on winning sectors.

Diversification can mean many things -- small versus large stocks, dividends versus growth stocks, and so on -- but most often it's taken to mean spreading your bets among a variety of industries. Of course, just because you want to have some exposure to a variety of industries doesn't mean that you want to have the same amount of exposure to all industries.

So what of the materials sector? Should we be digging in or pulling back right now? Let's take a look.

Performance
Here's a look at how performance has broken down among the S&P 500 industries:

Source: Standard & Poor's as of June 1.

When it comes to metals and materials, the state of the global economy rules the day. If the economy is buzzing along there will be plenty of demand for metals like aluminum, steel, and copper; chemicals like fertilizers, pesticides, and industrial chemicals; and timber and construction materials. That not only pushes up sales volumes, but for the companies selling commodities, it also gooses sales prices.

And if we can believe the bold statement in a recent presentation from Brazil's Vale (NYSE: VALE) -- "The great recession is history. A manufacturing boom is under way supporting a strong demand for minerals and metals" -- then it may be worth shrugging off recent underperformance and taking a hard look at the companies in the materials sector.

Let's take a closer look
Here's a peek under the hood of some of the major U.S. materials stocks.

Source: Capital IQ, a Standard & Poor's company.

Though the sector as a whole is broadly driven by the direction of the economy, the companies involved still vary considerably.

DuPont and Dow provide a dizzying array of chemicals and other synthetic products, including agricultural pesticides, brake fluid, insulation, adhesives, display films, bulletproof vest material, and a heck of a lot in between. Monsanto joins these two in the chemicals segment, though it focuses primarily on agricultural products. While the economy has a lot to do with the performance of the chemical companies, the companies with greater exposure to noncommodity products -- like DuPont's Kevlar or Monsanto's genetically engineered seeds -- have better protection against economic crunches.

In the metals subsector of this group, most companies -- including copper giant Freeport-McMoRan and aluminum producer Alcoa -- live and die based on demand for metals as well as their operational efficiency. Expansion and building around the globe -- as we've seen in high-growth areas like China -- can be big boons for these companies. And though we could say that gold producers like Newmont are similarly driven by demand for the metal and operational efficiency, these companies depend on the gold market, which is largely driven by its own set of forces, including investors.

The often forgotten corner of the materials sector contains companies like Weyerhaeuser and Vulcan Materials in areas like paper and forest products, construction materials, and containers and packaging. As these companies largely provide commodity products, efficiency and solid management that's able to pilot their companies through the cyclical swings are crucial.

Though I've listed U.S. companies above, we don't want to ignore the global giants in this sector. Australia's BHP Billiton, Brazil's Vale, and the U.K.'s Rio Tinto are driven by similar forces as their U.S. counterparts, but dwarf them in size and offer significant diversity in the materials they mine.

Putting it all together
Currently, to be equal-weight to the S&P in materials stocks, you'd need roughly 3% to 4% of your portfolio in these names. That's a pretty low hurdle, and I think investors should have at least that much exposure.

But should you gobble up more of these material names? I think it depends a lot on how you approach your portfolio. If you like companies that are stable and relatively predictable, then being equal-weight should be just fine. The big chemical companies like Dow, DuPont, and Monsanto might be good picks, along with global giants like BHP and Vale.

For those that can handle a little less predictability, the economic recovery and growth in emerging markets may be a good reason to be overweight in the materials sector -- particularly when it comes to the miners. The voracious appetite that emerging markets have had for raw materials could mean big profits for the global mining giants, as well as fertilizer producers like PotashCorp (NYSE: POT) and steel producers like ArcelorMittal.

But be wary, the cyclical swings in these companies can be huge, and while a low price-to-earnings ratio can mean "cheap" in other sectors, it can just as easily mean "peaking" in this group.

Many investors think gold is a pretty exciting investment. Well, this stock may be even better than gold.