Many people never think about just how involved the process is to bring even the simplest consumer goods to market. In order to produce the things you buy, manufacturers have to find and gather the basic materials that are necessary to make them work. To serve the needs of those manufacturers, an entire industry has emerged with the sole purpose of providing those basic materials for use in the products many take for granted. Let's take a closer look at the basic materials industry to learn more about exactly how it works and why it can be a fertile place for investors to seek solid returns.
What are basic materials?
Just about any required manufacturing input could qualify as a basic material. But the key basic materials that investors largely focus on fall into just a few major categories. Metals dominate the basic materials sector, with a substantial divide between precious metals and base industrial metals. Some companies specialize in producing gold, silver, platinum, palladium, and other rare, high-value metals. Others concentrate on aluminum, copper, iron ore, and steel, along with other less well-known but still common types of metals.
Chemicals are also important basic materials, with agricultural fertilizers having become a crucial part of food production and other performance chemicals going into products like paint as well as enhancing the quality and efficiency of a host of other goods. In addition, timber and forest-products companies provide useful basic materials, and other important construction materials such as wallboard are also included in the sector. A small number of investors include energy products, including crude oil, natural gas, and coal as well as refined products like gasoline and diesel fuel, as basic materials because of how important they are to most manufacturing processes, but the vast majority of analysts put energy companies in their own separate sector.
How big is the basic materials industry?
For U.S. investors, the basic materials sector is relatively small compared to the rest of the market. Within the S&P 500, basic materials stocks make up only about 3.5% of the total market capitalization, making it one of the smallest sectors of the U.S. large-cap stock market.
Worldwide, though, basic materials are a huge business, with entire national economies relying on their mineral wealth for their overall prosperity and with tens of trillions of dollars in resources available across the globe. Brazil, for instance, has more than a billion acres of timber reserves, and it exports huge quantities of other basic materials to China and other resource-hungry economies to feed their manufacturing industries. Similarly, China and other key materials buyers have turned to Africa as a potential new source of valuable resources, with vast mineral wealth going well beyond established areas like South Africa's gold and platinum-group metals mines. Russia also makes up a key source of basic materials, with unparalleled timber and mineral wealth that goes hand in hand with its extensive energy resources.
How does the basic materials industry work?
Companies focusing on basic materials have to go through many steps in order to see their business thrive. First, companies have to find areas where the resources that go into basic materials are plentiful, making arrangements to acquire the rights to extract them. In most cases, the raw materials that companies obtain need further refining in order to produce the basic materials that their customers want, and so companies then have to decide whether to put the necessary infrastructure in place at locations close to where natural resources are or to choose alternative sites and arrange for transportation of the raw materials for refining.
At the other end of the supply chain, basic materials companies also have to have effective marketing strategies to find customers for their products. With most basic materials being commodities that aren't readily distinguishable from one supplier to the next, nearly all of the competition is based on cost, and so companies are always looking for ways to differentiate themselves from their rivals through higher quality or the ability to provide value-added manufacturing or other services for their customers rather than simply giving them the most basic raw materials.
What drives the basic materials industry?
In large part, simple supply and demand dynamics are the key driver of the basic materials industry. Nowhere is that more evident than in the rise and fall of precious metals over the past 15 years. During the 2000s, prices of gold and other precious metals soared, as a rise in demand among investors and consumers helped to drive the market to new record highs. That in turn led to a huge upsurge of activity in the precious-metals mining industry, with established players ramping up their capacity while smaller new companies sought their fortunes through exploration activity. As prices hit their highs in 2012, demand finally started to peak, and with more supply coming into the market from past mining investment, the plunge in precious metals over the past two years as a natural consequence.
Other macroeconomic factors have major impacts on the industry as well. Low interest rates can make it easier to finance exploration projects, processing plants, and other capital-intensive investments. Currency fluctuations can give basic materials producers in certain countries a competitive advantage over those in other countries.
Overall, the basic materials industry relies on a healthy global manufacturing economy for its success. If manufacturers have strong demand for their end products, then they in turn have to turn to basic materials suppliers in order to boost their own capacity. Investors in basic materials have to keep their eyes on the global business cycle to get a sense of how promising the sector is at any given time.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.