By
Morningstar
:
By Robert Goldsborough
The global economy generally has improved, but investor concerns
persist both in Europe, where debt problems loom large, and in
China, where growth clearly is slowing. In the steel subsector of
the broader industrial sector, we have found that while steel
companies aren't immune from any slowdown, they have shown
themselves to be better managed than in the past and able to affect
steel prices by adjusting supply far more strategically.
How have steel companies been able to alter their industry
dynamics? In recent years, industry players have changed what
drives higher steel prices. Historically, the maxim was that
stronger demand drove higher steel prices. Now, given steel makers'
increasing willingness to adjust production to meet demand, supply
actually plays a much greater role in determining steel prices than
it once did. Steel buyers and distributors manage their working
capital better and operate with much smaller inventories than in
the past. So, short-term supply changes can have a much greater
impact on steel prices than they used to by giving the impression
of shortages during periods of lean supply chains. More steel mills
and steel buyers are shifting to lean inventories, given the drag
on the companies' earnings during the downturn from carrying
higher-cost inventories.
In 2011, the steel industry was hit hard amid global concerns
about the health of the European economy and the magnitude of a
slowdown in China. While these are very real problems, we view them
as shorter-term concerns and do not believe that fundamentals will
deteriorate to the severe degree implied by steel firms' market
prices. Even as global demand appears to be weakening, likely
creating some oversupply in our view, this has been to some extent
offset by positive impacts on the raw-materials front, with lower
iron ore and coal costs. So, industry players' margins should hold
up.
Longer term, we believe that captive raw materials and efficient
operations are among the keys to solid profits in steel making,
with vertical integration less important and input prices now
displaying greater volatility than in the past. Given the
volatility of the industry over the past few years, any investor
looking to invest in steel companies should prepare for a bumpy
ride. We believe that investors still should remember the usual
caveats about the volatility of steel prices relative to the
volatility of other industrial subsectors.
An ETF for Investors Interested in Steel Companies
Market Vectors Steel ETF (
SLX
), which charges 0.55%, holds the largest global steel companies
across the entire steel industry supply chain. That means this fund
holds large iron ore miners such as Rio Tinto (
RIO
) and Cliffs Natural Resources (
CLF
) and actual steel manufacturers themselves such as Nucor (
NUE
) and U.S. Steel (
X
).
Right now, SLX is one of the single most attractively valued
exchange-traded fund available. Why? The fund always has faced a
lot of cyclicality--its five-year beta compared with the S&P
500 is 1.43, meaning that all else equal, the fund would be
expected to perform 42% better than the benchmark in an up market
and 42% worse in a down market. However, the reasons for the
valuation disconnect go deeper than that. Morningstar equity
analysts believe that particularly given uncertainty over the
economic situation in Europe and slowing in China (which is fully
half of the world's steel consumption), investors are steering
clear for now.
We think that's a mistake. As noted above, steel companies are
much better-run companies than in the past, able to adjust capacity
and sustain their margins even in times of weakness among their end
markets. What's more, we believe that steel prices should remain
reasonably high, given a lack of imminent new product capacity of
iron ore. And we believe that the global issues that the industry
is facing right now are short term in nature--the market is
completely discounting future infrastructure growth in emerging
markets.
Portfolio Construction
SLX tracks an index of 26 publicly traded companies primarily
involved in producing steel products or mining and processing iron
ore. Given its market-cap-weighting scheme, SLX tilts heavily
toward large steel companies. SLX's average market cap is about
$12.5 billion, and the top five companies soak up almost 41% of
assets. Because the industry's largest players are domiciled
abroad, the fund is globally diversified: North American companies
comprise 46.5% of the fund's assets, followed by Latin American
firms (24%) and European firms (12%). Although iron ore miners make
up a decent percentage of SLX's holdings, the fund excludes the
world's largest mining company, BHP Billiton (BHP).
Alternatives
PowerShares Global Steel (PSTL) is the only other pure-play steel
ETF. It's much smaller and far less liquid than PSTL. It also
offers slightly different exposure. Although it also is market-cap
weighted, it holds a broader portfolio of 70 firms. In addition,
PSTL's holdings are listed all around the globe, while SLX's
portfolio consists only of firms that trade in the United States.
Despite these small differences, PSTL and SLX show a 96%
correlation since PSTL's launch in September 2008. PSTL charges
0.75%.
SPDR S&P Metals & Mining (XME) (0.35% expense ratio) is
a broader mining-oriented fund. XME devotes just 33% of assets to
steel companies, with the remaining two thirds of assets invested
in metals, mining, coal, and precious-metals companies. SLX and XME
are 96% correlated over the past five years.
ArcelorMittal (MT), which is far and away the world's largest
steel producer, is a non-ETF alternative. The company also is the
world's fourth-largest iron miner, supplies one fifth of the global
automotive market's steel needs, and is the number-one or
number-two steel producer in every major region of the world except
for East Asia. Morningstar equity analysts assign MT a narrow moat
rating, meaning that they believe the company has some sustainable
competitive advantages.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
FedEx Reports Earnings June 19 - When Operating
Leverage Becomes A Drag
on seekingalpha.com