3 Stocks to Watch in Chemicals

The word chemicals conjures up images of mad scientists and fancy laboratories. But the truth is that chemicals get used every day to produce the products you use every day. This is exactly why you'll want to watch the chemicals industry. And these three giants are all worth keeping an eye on as they look to become more specialized: Dow Chemical Co (NYSE: DOW), Eastman Chemical Company (NYSE: EMN), and from a slightly different angle, Phillips 66 (NYSE: PSX).

More than 100 yearsDow Chemical's history goes back well over 100 years to the late 1800s and the production of bromide. Today, Dow is among the largest chemicals companies in the world, and serves industries as diverse as agriculture, construction, and electronics, among many others.

One of Dow's many products. Source: JonRHanna, via Wikimedia Commons.

The thing with chemicals is that there are really two distinct ways to go: commodity chemicals and specialty chemicals. Historically, Dow has played in both spaces, but it has been movinh more toward the specialty area. That's included plans to spin off some businesses, as well as focus on research and development.

Why make this shift? Specialty chemicals generally require close contact with customers to create products that meet very specific needs. Such relationships tend to be enduring, and provide more stable revenue streams than bulk commodity chemicals, where low-cost production is the biggest determinant of success. It's worth noting that the company's operating margin has increased from the low single digits toward the end of the last decade to the high single digits last year. So it looks like things are going in the right direction. So, watch Dow and its shift toward specialty chemicals.

Buying and selling successEastman Chemicals is another large chemical company with a varied list of products. It's no surprise that it has been working on specialization, too. One of its key levers here has been portfolio management.

For example, during the decade between 2004 and 2014, the company took revenues from $6.6 billion to around $9.5 billion while divesting businesses with $3.5 billion in revenues. How do you do that? By aggressively working on partnerships and acquisitions.

A potential social issue for Eastman. Source: Akroti, via Wikimedia Commons.

More important to the bottom line, the businesses sold had EBITDA margins below 10%, while the new businesses had margins of 25% or so. (This shows exactly why most large chemical companies want to refocus around specialty chemicals, by the way.) But at the end of the day, you'll want to keep an eye on Eastman because it's a pretty aggressive mover and shaker in the chemicals industry.

There are two important things to know about Eastman. First, while competitors mostly focus on using oil and natural gas as the building blocks for their chemicals, Eastman also includes coal in the mix. That helps keep costs down, and can provide a competitive price advantage.

The other thing of note is that Eastman does a big business in chemicals used in cigarette filters. That's an industry in slow decline domestically; but many see it as growth oriented in developing markets. It also happens to be an industry that many investors try to avoid. So keep that in mind when examining this chemical maker.

Outside the boxAnother company that might interest you in the chemicals space is Phillips 66. No, it isn't a pure play chemical company, it describes itself as an energy manufacturing and logistics company. But it happens to be 50% owner of Chevron Phillips Chemical Company, or CP Chemicals for short, a partnership started in mid-2000. Today CP Chemicals is a top chemical producer with facilities around the world.

The interesting thing about CP Chemicals, however, is that it has been building new plants and expanding existing ones to take advantage of low-cost U.S. natural gas. These expansion plans should help keep the top- and bottom-lines growing as well as position it to keep costs, as noted a key factor, at low levels. It has a $6 billion "mega" project scheduled to come online in 2017 that will increase the chemical company's domestic olefins and polyolefins capacity by roughly 33%. However, company executives have said they are already looking for the next giant project to tackle. So growth is a real focus right now.

The interesting thing about this with regard to Phillips 66 is that Phillips 66 sees chemicals is one of its two growth businesses. So expect chemicals to become more and more important to Phillips 66 as time goes onwith CP Chemicals' new low cost facilities leading the way. And while you could invest in its partner in CP Chemicals, smaller Phillips 66 will likely provide more exposure to this growing business.

Plenty of optionsThe chemicals industry is huge. Dow and Eastman are just two in a crowded field. That said, if you are watching the chemicals industry, they are important names to keep an eye on. And you might find that they are also the very companies you end up wanting to own as they become more and more specialized and work to keep costs as low as possible. That said, Phillips 66 shows they aren't the only way to get chemicals exposure if you are willing to dabble a little further in the energy space.

The article 3 Stocks to Watch in Chemicals originally appeared on Fool.com.

Reuben Brewer 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.

Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.