Metal Turnaround Stocks: From Laggards To Leaders

Submitted by George Putnam, III as part of our contributors program.

In 2012, most asset classes (such as stocks and bonds) performed well, but a noticeable laggard was commodities and commodity-related investments. Among other things, that asset class was hurt by concerns about the downturn in the European economies and a possible slowdown in China. As a result, the steel and aluminum stocks were among the worst performers in the global stock markets.

This grabbed our attention for two reasons, one technical and the other fundamental. On the technical side, investor views can change rapidly, and we’ve often seen one year’s losers become the next year’s winners.

On the fundamental side, there are several economic factors that could work to the benefit of the metals producers. Over the last decade or so, there has been steady consolidation in the sector. Large producers have gobbled up smaller producers around the globe, thereby reducing competition. Low energy prices in North America will help the U.S. metals companies. There are signs of a nascent rebound in construction in the U.S.–homebuilding is already on the mend, and commercial construction usually follows. There are also signs that the slowdown in China may not be as great as many investors feared.

Put all these things together and it makes the steel and aluminum stocks look like very attractive turnaround investment candidates. The stocks discussed below are all large, global producers that would benefit greatly from a rebound in the sector.

AK Steel Holding’s (AKS) roots go back to the late 1800’s; its present form came a century later out of a partnership between Armco and Kawasaki. AK is one of the most leveraged steel producers, which adds to the risk in the stock. But it also gives the stock the most powerful rebound potential if industry conditions do improve. Several recent actions have improved the balance sheet somewhat, and it looks like the company has sufficient resources for at least the next couple of years.

Alcoa (AA) is one of the world’s leading makers of aluminum. With its sensitivity to general economic conditions, particularly in the automotive and construction industries, it should not be a surprise that the stock has languished since the end of the last recession. But Alcoa has reduced operating costs, in part, by switching some manufacturing to natural gas. In addition, several industry players, including Alcoa, have reduced capacity. As a result, aluminum pricing is beginning to strengthen. With solid financials, look for Alcoa to perform well as global economic confidence improves.

Aluminum Corp. of China (Chinalco) (ACH) is China’s largest producer of alumina (the raw material for aluminum) as well as its largest aluminum fabricator. As the Chinese market struggles with potential over-capacity, Chinalco is seeking to manage costs as well as expand into other related markets, such as copper, coal, iron ore and rare earth metals. While there is evidence of overbuilding in areas of China, the stock has strong rebound potential if economic growth picks up again there.

ArcelorMittal (MT) is based in Luxembourg, but it has a presence in more than 60 countries. The company claims to be the world’s leading steel and mining company with leadership positions in the automotive, appliance, packaging and construction markets. Considerable exposure to Europe has crimped operating results. But management is being aggressive in rationalizing operations, cutting the dividend and firming up the balance sheet with new issues of stock and subordinated notes.

Gerdau S.A. (GGB) is a Brazilian-based steel manufacturing company. It has a strong presence in South America but also operates in the U.S., Canada, Spain and India. Gerdau has faced all of the problems that the industry has endured in recent years, but its home-field advantage in Brazil and South America positions it well for future growth. Among other sources of regional stimulation will be the 2014 World Cup and the 2016 Summer Olympics.

Nucor (NUE) is the largest U.S. operator of mini-mills, smaller steel facilities that use scrap as their raw material. The firm’s electric arc furnaces are more versatile and more energy efficient than competitors’ blast furnace operations. Arc furnaces have allowed Nucor to quickly adapt production levels to final demand, a flexibility that helped management maintain the firm’s financial strength during the latest downturn. The company has a number of growth initiatives, including new natural-gas furnace operations, strategic acquisitions and international joint ventures. Nucor has a record of 40 years of dividend increases, a record that is likely to be extended in 2013.

Posco (PKX) is the largest steel producer in S. Korea and one of the largest in the world. The bulk of sales are to the Korean market, with China and Japan also being significant. The company’s exposure to autos and shipbuilding hurt during the latest recession, but it remains competitive and solidly financed. It recently joined a consortium to buy a mine responsible for 40% of Canada’s iron ore production. With its strong Asian presence, Posco appears cheaply valued.

Steel Dynamics (STLD) was formed in 1993 by former Nucor employees. Ever since, the management team has received high marks for having created a well diversified, vertically integrated, low-cost mini-mill operation. In recent years, the company has done a good job of weathering the cyclical downturn in its most important markets, construction, autos and machinery. Steel Dynamics will be an important industry force in the years to come.

Tenaris S.A. (TS), headquartered in Luxemburg, makes steel tubing and related products that are used primarily by the oil & gas industry. Other important markets include power generation, industrial products and automotive. Despite tough headwinds, operations have remained sufficiently profitable to allow for a substantial reduction in debt. Having expanded globally, Tenaris is now well positioned to leverage off a rebounding energy sector.

US Steel (X), with operations dating back to 1901, is one of the world’s largest integrated steel producers. The last several years have been bumpy for the company, but today it is well situated to capitalize on a rebound in the auto sector, which accounts for about 30% of sales. It should also benefit from a rebound in the energy sector via its tubing operations. The balance sheet is decent enough, although it does have an overhang of unfunded pension and healthcare liabilities. Even so, the stock looks attractive, and there is a good chance of upside surprises in 2013.