The Value Case for Steel Stocks


JThe CPI numbers from his morning highlighted one thing: inflation is still raging. That doesn’t mean investors should get rid of stocks, of course. It’s never a good idea. The timing of such a move is always difficult, and it is difficult to estimate how much bad news is priced in at any given time, which makes the timing of re-entry into the market even more difficult. Numerous studies have shown that investors who weather periods like this do better than those who try to time the market.

What, if anything, should investors do to prepare their portfolios for an environment of 9.1% inflation and the aggressive rate hikes that will surely follow that report?

First of all, while extreme movements would be a mistake, just sitting on your hands isn’t the best way to go either. Inflation, and more importantly the Fed’s response to it, have fundamentally changed both current conditions and the economic outlook. This means that some changes may be required. The Fed will actively try to suppress growth, so stocks that derive their value from anticipated growth are less attractive than those whose price has been pulled down with the market to the point where they offer earnings-based value. , book value and others. simple measures

This means looking for companies in sectors and industries that have sold off with stocks in general, but where the decline appears to have been exaggerated. Ideally, they should have decent cash positions and balance sheets that will allow them to weather any downturn and have some protection against inflation-induced margin pressure.

Stocks in the steel industry seem to fit these criteria.

The bearish case for steel stocks is obvious and often stated. Cars, appliances and other important markets for their products are usually hit early and hard when the economy turns south. It is partly for this reason that steel prices have fallen and the two largest American steel companies, US Steel (X) and Cleveland Cliffs (CLF), have both recorded big losses in their stocks since that they peaked in April:

CLF Chart

As you can see, the charts for these stocks look nearly identical, indicating that the moves are based on perceptions of their industry rather than company-specific factors. Interestingly, however, stocks in general hit their highs in early January, but steel stocks soared during initial volatility and didn’t turn around until April. Indeed, materials, the sector in which they are placed, are seen more as a hedge against inflation than as a sector affected by rising prices. After all, they own a large amount of a basic good, and the price of that good will rise with inflation, giving them easy profits.

However, once the Fed took the second quarter rate hike seriously, fear of a recession outweighed this positive sentiment. As I’ve said here many times, fear-based movements are emotional and as such tend to be overdone. The numbers suggest that’s what happened with X and CLF.

The most basic valuation measure is the trailing P/E, the price of a stock relative to its last twelve months of reported earnings. The average P/E for the S&P 500 is currently 21.07, while X and CLF have P/Es of 1.0 and 2.28, respectively. The same level of value is evident if we look at the price-to-book ratio: 0.47 for US Steel and 1.28 for Cleveland Cliffs.

Clearly, both stocks qualify on the value front, but what about balance sheets and pricing power? US Steel has nearly $3 billion in cash, free cash flow of more than $2 billion and debt of just over $4 billion, while CLF has $35 million. of cash, free cash flow of $1.34 billion and debt of $5.03 billion.

As for pricing power in an inflationary environment, both have it in some respects, if not others. They lack it because steel is a global commodity and steel prices have fallen by about half since April as China shut down and the war in Ukraine dragged on . Stocks followed suit, but that forgets something: between them, US Steel and Cleveland Cliffs control 100% of US iron ore production. This gives them a big advantage in terms of input prices and will allow them to compensate to some extent for the reduction in margins. On the demand side, it is entirely possible that even if growth is slowed or stopped by central banks, it will come at the same time as China reopens, giving a boost to steel.

X and CLF are cheap and the sale of their shares seems like a big stretch. The balance sheet figures favor X as an investment. CLF, however, currently has an aggressive share buyback program and has been on a rapid improvement path for a few years under its current CEO, so may have more upside in some respects. Whether you like one, the other or both, however, steel stocks should be on your list of bargains where the negatives of inflation seem well priced in and offer good long-term upside.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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