3 chemical stocks to play the industry breakout

I hope you're the type of investor who will sit down and do the homework required to come out as a winner in the financial markets. When you do, you'll notice that the big guys at places like The Goldman Sachs Group NYSE: GS and other respectable investment houses generate their ideas through a process called 'top-down' research. In this case, we'll do some of that for you.

One of the easiest ways to keep up with the economy's pulse and a reliable way to catch new and developing trends in specific industries is to follow the monthly changes within the ISM PMI reports, manufacturing, and services. For January, you will notice the perfect turnaround play within the chemical stocks sector, which is precisely what Goldman is looking for, but more on that later.

For now, all you need to worry about is why stocks like Valvoline NYSE: VVV, Stepan NYSE: SCL, and even Ashland NYSE: ASH could be some worthy additions to your portfolio in the coming quarter. Remember that, according to the FedWatch tool at the CME Group NYSE: CME, your deadline to consider these stocks ends in May of this year, when markets are betting the FED will cut interest rates.

Is now the time?

How can you decide to open up your brokerage and look to potentially buy any of these names? Well, typically, uncertainty creates doubt, and doubt creates fear. Here is how you can understand what is happening behind the scenes of the economy and hopefully reduce that uncertainty so you can operate more confidently.

In the past three months of manufacturing data, covering the months of November, December, and now January, the chemical industry contracted for two-thirds of that period. January showed the space expanding for the first time in the quarter. In a month where only four industries expanded, that's kind of a big deal.

Within their 2024 macro outlook report, Goldman Sachs expressed their expectation of a manufacturing turnaround and breakout for the year. Supporting this thesis is the potential rate cuts coming from the FED (which may come as soon as May). Since markets are forward-looking, you may want to look into stocks to buy before the money shift is here.

What better way to pick a turnaround play than the chemical space? After contracting in November and December, the sector finally expanded on extended demand and sentiment, showing that "Sales are above expectations," as executives expressed in the respondent section of the PMI.

Breaking apart the performances between the Industrial Select Sector SPDR Fund NYSEARCA: XLI and the broader S&P 500 index, you will notice a six-month underperformance of 4.7% on the part of the industrial names. However, for the past quarter, they saw a comeback to outperform the market by nearly 1.5%.

While nothing to write home about, it is a starting sign of the times that 1.5% could quickly turn into double-digits once the rest of the market catches onto the new expanding wave of the sector. Of course, you can pick up the trend now or wait for further confirmation in the next set of PMI data.

Spoiled for choice

Breaking down the chemical industry, there are two things you have to focus on. First, remember how much the average earnings per share is set to grow for the next twelve months. Secondly, you can gauge how much markets are willing to pay today for tomorrow's earnings, achievable via the forward price-to-earnings (P/E) ratio.

As an average, this industry is set to grow its EPS by 17.6% over the next year, and those earnings trade at an average 13.9x forward P/E multiple. These benchmarks can help you identify the positive outliers that will grow the most once – or if – the industry pumps another month of growth per the PMI.

So, what specific stocks should you consider? 

Let's start with Valvoline. VVV stock is projected to grow earnings by 23.1%, above the industry average. Its 18.5x forward P/E calls for a justified premium value of 32.9%; think of the saying, "It must be expensive for a reason," and now you know why. Even analysts at Morgan Stanley NYSE: MS see the writing on the wall, as they boosted their price targets to up to $44.0 a share, a 22.2% upside from today.

Stepan stock has also been attracting institutional investors, as Russell Investment Group has upped its stake by as much as 30.7% in February. Analysts see its EPS jumping by as much as 63.7% this year, justifying its 29.8% premium valuation to the sector via its 18.0x forward P/E.

Last but not least, Ashland stock has analysts pushing for 43.3% advances in EPS for the next twelve months. Its 14.4% premium value to the sector seems conservative to where this stock could be trading. This could be why analysts at Wells Fargo NYSE: WFC boosted their price targets to $100.0 a share this month, implying a 10.2% upside from today's prices.

A sector ready to potentially keep on going in an expansion after suffering from downward pressure, and the best stocks within the space to bring the odds in your favor, what's not to like?