Steel stocks are highly cyclical and are practically the definition of a “down the food chain” sector—if a big industry or two slows down, demand for steel can fall dramatically, slashing prices, utilization and profits. That’s basically what’s happened during the past few years, as a flood of imports and slowing demand from energy firms (for tubing and related products) has made a mess of the group; from July 2014 through January of this year, the sector plunged 70%! Like many beaten-down groups, steel stocks are now on the comeback trail—steel prices are rebounding as imports decline (thanks to the imposition of huge tariffs on cold-rolled steel from many countries, including China), and a couple of key customer end markets appear likely to drive demand. Moreover, the sector itself is back above its 200-day line, unlike most of its commodity-related peers. Now, just because the future looks a bit brighter doesn’t mean we’re rushing to buy steel stocks, but it has prompted us to dig into the group, and one stock caught our eye. Steel Dynamics (STLD) is by far the most efficient steel producer in the sector; it gets about 80% of revenues from steel production and fabrication, with the rest from metals recycling. More than 80% of its costs are variable and it focuses on so-called value-added sheet steel (specially engineered and higher priced), which helps it stay in the black no matter the environment.
The company made 73 cents per share last year, and even cranked out a profit in 2009 when the sector’s sky was falling. During the past five years (hardly a boom time for the industry), Steel Dynamics produced about $2.1 billion of free cash flow (more than $8.50 per share cumulatively, including north of $3.50 last year alone), which it’s used to pay down debt and fund a solid dividend (annual yield of 2.5%).
More important at this point are Steel Dyanmics’ prospects for growth, and there are many—the tariff (which is already boosting prices), its recent acquisition of a Columbus, Ohio mill, and its focus on customers that are in a solid growth mode, specifically automotive and construction, which make up nearly half of all shipments. Analysts see earnings rising 80% this year and another 30% in 2017, though, admittedly, those outlooks can change in a hurry.
The stock itself corrected “only” 40% from July 2014 through this January (versus 70% for the group), and it’s now rallied strongly to within about 10% of multi-year highs. It’s not revolutionary, of course, but if steel stocks really have bottomed out, STLD could do very well. It’s on our watch list.
The Music is Always Changing
In the Lunch with the Analyst webinar I did last week (you can see it at http://www.cabot.net/videos/webinars/2015/lunch-with-the-analyst-2016-03-22), one of my first slides was titled “The Music is Always Changing,” which means the character of the market and individual stocks often switches at a drop of a hat. This is why we urge you to avoid bold predictions about the future, as most involve assuming the current market action will continue indefinitely.
The example I gave in the webinar was the relationship between crude oil and the market; the correlation has been nearly one-to-one, and thus every investor is following it closely. But don’t assume the market will always take its cue from oil prices—a few months from now, it could be currencies, interest rates, earnings, or who knows what else.
Preconceived notions are even more dangerous when it comes to individual stocks. Take a look at Restoration Hardware (RH), a stock we followed for more than a year (and owned a couple of times, too). For much of 2014 and 2015, RH bobbed up and down in 20%-ish waves, hitting slightly higher highs and higher lows for more than a year. Every push to new highs attracted sellers, while every multi-week dip was buyable after a few down weeks.
But out of nowhere, the music changed last November in a big way. RH completely changed character, dipping from 106 to 80 by the end of the year, then imploding through February, falling below 40, losing two-thirds of its value! While there was a disappointing earnings report in there, it’s not as if business has evaporated; analysts still anticipate earnings north of $2.50 per share this year. What really happened is that investor perception tanked.
Obviously, RH is an extreme example, but as Jesse Livermore observed, it’s just these kinds of extreme situations that the investor must work to avoid. Thus, whether it’s the market, a sector or an individual stock, don’t get lulled into a false sense of security—it’s best just to take things week by week and follow your plan.