The Value Case for Steel Stocks

This morning’s CPI numbers made one thing clear: inflation is still raging. That doesn’t mean that investors should be clearing out of stocks, of course. That is never a good idea. The timing of such a move is always difficult, and it is hard to estimate how much bad news is priced in at any given moment, making the timing of one’s re-entry into the market even harder. Study after study has shown that investors who ride out times like this do better than those who try to time the market.

What, if anything, should investors be doing to prepare their portfolio for an environment with 9.1% inflation and the aggressive rate hikes that will surely follow this report?

First, even though extreme moves would be a mistake, just sitting on your hands is not the best way forward either. Inflation, and more importantly the Fed’s response to it, have fundamentally altered both current conditions and the economic outlook. That means some changes may be necessary. The Fed will be actively trying to suppress growth, so stocks that derive their value from anticipated growth are less attractive than those whose price has been dragged down with the market to the point where they offer value based on trailing earnings, book value, and other simple metrics

That means looking for companies in sectors and industries that have been sold off with stocks in general, but where the drop looks to have been overdone. Ideally, they should have decent cash positions and balance sheets that will enable them to survive any downturn and have some protection against the margin pressure that inflation brings.

Stocks in the steel industry seem to fit those criteria.

The bear case for steel stocks is obvious and oft stated. Cars, appliances, and other important markets for their products typically get hit early and hard when the economy turns south. That is in part why steel prices have dropped and the two largest U.S. steel companies, US Steel (X) and Cleveland Cliffs (CLF), have both posted big losses in their stocks since hitting highs in April:

As you can see, the charts for those stocks look almost identical, indicating that the moves are based on perceptions of their industry rather than company-specific factors. Interestingly, though, stocks in general hit their highs in early January, but steel stocks climbed through the early volatility, and didn’t turn until April. That is because materials, the sector in which they are placed, is seen more as an inflation hedge than one adversely affected by rising prices. After all, they own a lot of a basic good, and that good's price will rise with inflation, giving them easy profits.

Once the Fed got serious about raising rates in the second quarter, though, the fear of a recession outweighed that positive feeling. As I have said here many times, fear-based moves are emotional, and as such tend to be overdone. The numbers suggest that that is what has happened with X and CLF.

The most basic valuation measure is trailing P/E, a stock’s price relative to its last twelve months of reported earnings. The S&P 500 average P/E right now is 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 price to book value: 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 of cash on hand, free cash flow of over $2 billion, and debt of just over $4 billion, while CLF has $35 million in cash, free cash flow of $1.34 billion, and debt of $5.03 billion.

As for pricing power in an inflationary environment, both have that in some ways, if not in others. They lack it because steel is a global commodity, and steel prices have fallen by around half since April as China has shut back down and the war in Ukraine has dragged on. The stocks have followed that move but that overlooks something: between them, US Steel and Cleveland Cliffs control 100% of U.S. iron ore output. That gives them a big advantage in terms of input pricing and will enable them to offset margin reduction to some degree. On the demand side, it is quite possible that even if growth is slowed or stopped by central banks, that will come at the same time as China re-opens, giving steel a boost.

Both X and CLF are cheap and the selloff in their stocks looks way overdone. The balance sheet numbers favor X as an investment. CLF, though, currently has an aggressive stock buyback program and have been on a rapidly improving track for a few years under their current CEO, so may have more upside in some ways. Whether you like one, the other, or both, though, steel stocks should be on your list of bargains where the negatives of inflation look well priced in, and that 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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