Whenever investors fear economic weakness, the stocks they flee first tend to be in cyclical industries that are also capital-intensive. Likewise, investors tend to return to these stocks last as the economy recovers. Such is the case in the steel industry, where ArcelorMittal (ADR) (NYSE:MT) cannot seem to catch a bid in the current bull market.
Bleak short-term outlook
There are countless companies that seem cheap, but many have competitive situations that make their futures difficult to ascertain. As a company whose profits are dictated by the market price of a commodity product, ArcelorMittal is hardly in control of its own future.
However, as the largest steel producer in the world, the company’s prospects are significantly better than its competitors. As a result, the company is likely to perform much better than its peers when the inevitable upswing in steel prices comes to fruition.
The stock trades for just 40% of book value, but not without reason. ArcelorMittal (ADR) (NYSE:MT)’s profitability has evaporated due to plunging steel prices caused by low economic activity in Western Europe and throughout the developed world.
Meanwhile, emerging economies — especially China — are ramping up steel production to supply their fast-growing economies. This will add even more supply to a market that already has a lot more sellers than buyers.
Always look at the big picture
Of course, the market is all too aware of these headwinds. David Dreman, the famous contrarian investor, frequently points out that investors are too focused on the last data point. Instead, Dreman says investors should focus on the big picture — what the company has done over many years, not just what happened last year.
Investors who look at ArcelorMittal (ADR) (NYSE:MT)’s long-term operating history will find that a 7% to 8% return on equity is a conservative estimate of the company’s normal earning power. A company that consistently earns an 8% return on equity should trade at least 80% of book value — roughly double what the stock trades for now.
ArcelorMittal (ADR) (NYSE:MT) does not earn anything close to an 8% return on equity today, but there is reason to believe that it will do so again in the future. Besides a rebound in steel prices, the company’s competitive position will allow it to return to higher profitability.
As the largest company in an industry where scale is the primary competitive advantage, ArcelorMittal has an enormous advantage over other companies. United States Steel Corporation (NYSE:X), for example, cannot export steel to international markets as cheaply as ArcelorMittal because its operations are concentrated within the continental United States.
United States Steel Corporation (NYSE:X) makes up for its disadvantage in scale by owning and operating many of the mines from which it buys raw materials. This puts it on even footing with ArcelorMittal (ADR) (NYSE:MT) as far as international margins are concern, but ArcelorMittal is still able to produce and deliver larger quantities in a shorter amount of time than its U.S.-based counterpart, giving it a slight advantage in international markets.
