Three Leading Chemical Stocks to Buy With History on Their Side

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The U.S. chemical sector has enjoyed significant tailwinds over the past 15 years -- starting at a steep discount to the S&P 500 due to the tech bubble; improving return on invested capital (ROIC) driven by better operating cultures, consolidation and customers more focused on supply-chain resilience than costs after Hurricane Katrina; and a widening feedstock advantage. As a result, the chemical sector has outperformed the S&P 500 in two-thirds of the past 15 years. Looking forward, 2014 looks to be another year of outperformance for the right stocks.

In a new report from Jefferies, this top performing sector is broken down into the three main metrics: EBITDA margins rankings, free cash flow (FCF) and return on equity (ROE). While only a small number of the top names screen well on all three, showing up well on all three is critical for forward performance. History has shown that making the list in all the top three categories is almost a guarantee of solid success.

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While it narrows the picks down to just three Buy-rated names, the chemical sector asset allocation in the typical portfolio would not be overweight at this time. Here are the top three chemical names to buy that fit the bill in all three of the top categories.

Huntsman Corp. (HUN), together with its subsidiaries, manufactures and sells differentiated organic and inorganic chemical products worldwide. The company operates in five segments: Polyurethanes, Performance Products, Advanced Materials, Textile Effects and Pigments. Huntsman posted a profit in the fourth quarter, helped by improved demand for pigments and polyurethanes used in foam insulation. The company's net income was $41 million, or $0.17 per share, in the quarter ended Dec. 31, compared with a loss of $40 million, or $0.17 per share, a year earlier. Revenue rose 3% to $2.71 billion. Investors are paid a 2.2% dividend. The Jefferies price target for the stock is $28. The Thomson/First Call estimate is at $26.92. Huntsman closed Tuesday at $23.45.

3M C0. (MMM) is the quintessential diversified large cap chemical stock for a blue chip portfolio. The company now operates five segments: consumer, industrial, health care, safety and graphics, and electronics and energy. The Dow giant recently announced a new $12 billion share repurchase plan that management says demonstrates the company's "commitment to returning significant cash to shareholders". Shareholders are paid a 2.6% dividend. The Jefferies price target is $150, and the consensus target is lower at $140.96. 3M closed at $131.80 on Tuesday.

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PPG Industries Inc. (PPG) is a top stock to buy at Jefferies, and a name that CNBC's Jim Cramer has been behind since 2009. With good reason. The specialty chemical maker has risen 358% since Cramer first started to champion the stock almost five years ago. Chairman and CEO Chuck Bunch said in a recent interview with the "Mad Money" host that despite today's headlines, he feels good about PPG's prospects in China. He said business remains good and the company expects a solid first quarter from the region. There was also positive news from another troubled region of the globe, Europe, where Bunch noted that PPG saw an encouraging fourth quarter with no volume declines. He said the European auto business is starting to show signs of life, which is very encouraging. With more challenging areas looking better, PPG could be poised for an outstanding 2014. The stock pays a 1.3% dividend. The Jefferies price target is $215, and the consensus is lower at $206. PPG closed at $185.98 on Tuesday.

For more than a decade, the U.S. chemicals sector has traded in a consistent way: companies with significant improvements in ROE outperformed their peers (by 18% a year, on average), companies with improving EBITDA margins outperformed their peers (by 27% a year, on average) and companies with positive FCF outperformed their peers (by almost 19% on average, however underperforming slightly in 2004, 2010 and 2013). With only three of the top stocks to buy, it makes the choice pretty simple. Buy the leaders in the three top metrics and your chances for success appear to be very high.

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