Ticking away the moments that make up a dull day
You fritter and waste the hours in an off-hand way
Kicking around on a piece of ground in your home town
Waiting for someone or something to show you the way
Tired of lying in the sunshine staying home to watch the rain
You are young and life is long and there is time to kill today
And then one day you find ten years have got behind you
No one told you when to run, you missed the starting gun
- Roger Waters
During June 2008, the shares of ArcelorMittal (MT) pranced over $100. Were you waiting for someone or something to show you the way: clearly the race was over. Today are you saying that no one told you when to run, you missed the starting gun. Songs aside, the race has begun; you can't be first, but perhaps you can win a prize just the same.
This post is about time arbitrage. It is about investing in a turnaround prospect. You form your expectation, and if you are right, one day in the future that will become the market expectation, and when that occurs, you will profit from it. When looking for a turnaround candidate, other people's expectations don't matter. What does matter is your expectation and conviction.
One way of searching for turnaround stories is to identify highly cyclical sectors and industries, with adverse present macro themes which you believe with high conviction will reverse in time. And then, in the space identified, search for companies trading at a very, very low Price-to-Peak Earnings ratio.
ArcelorMittal had its recent peak earnings in 2007, when its earnings hit $7.40 for the year. At that time Aperam was part of the company, and so we must reduce the prior peak earnings to $6.99 to eliminate the contribution from Aperam, which has been spun off. The share count has also increased from 1,386 million shares in 2007 to 1,665.39 million shares today, mainly because of shares issued to reduce the debt burden and improve the capital structure. Thus, the adjusted prior peak earnings are $5.88. This looks like a terrifyingly high bar to set, but such volatility is not uncommon in the very cyclical steel industry.
ArcelorMittal is one of my favorite time arbitrage and turnaround opportunities at present. Why? Because no one knows steel like Lakshmi Mittal does. He built ArcelorMittal from nothing, into the largest and highest quality steel company in the world today. And he started with nothing. When I get to buy the share at a substantial discount to book value, or below 100% of tangible book value, I buy.
That aside, as I travel about India, what I don't see is important. I don't see the required infrastructure anywhere. What I do see is ramshackled and dilapidated infrastructure; and that is equally important. Then travel through the developed world, and what do we find? Dilapidated in some instances, and deteriorating in the rest. The deterioration of infrastructure is visible in roads, bridges, airports, and while I have not visited a port, perhaps in ports too. The need for investment in infrastructure everywhere in the world is huge, and it's getting to a point where it's needed now, not tomorrow. And you cannot develop infrastructure, whether it's buildings, bridges, roads, airports, ports, pipeline, cars, buses, trucks, oil & gas storage and terminals, rail engines/carriages/tracks, or anything else, without steel. The need for steel is not a matter of if, but when. And with the elapse of time since the Great Recession, the "when" is fast becoming "now."
Besides the prospect of earnings expansion over the coming years, in the case of ArcelorMittal we have a potential catalyst which could drive price gains or declines. The company cut its dividend to $0.20 for 2013 from $0.75 during 2012. If the dividend is reinstated with an objective of debt reduction being met, it would be a positive. On the other hand, if the dividend is not hiked, we could see a price decline. I am not optimistic on reinstatement of the dividend, because if it were coming surely it would have been announced by now. The good news is whenever I am pessimistic, I am pleasantly surprised by actual events that occur!
Another potential catalyst for price gains is the prospect of a strengthening recovery in Europe. Strength in Europe would be a positive for ArcelorMittal because the company is of Luxembourg incorporation: improved sentiment in Europe will drive both business expansion and price gains.
ArcelorMittal comes with a beta of 2.26. I believe when the recovery gains momentum, ArcelorMittal with an improved capital structure, could see its beta contract to the steel industry average beta of 1.66. Reuters reports an average return on equity of 9.8% for the steel industry over the past five years, and this is a target which ArcelorMittal should achieve once sales expand because of the substantial overheads cost cuts undertaken during the past several years.
In the very long-term, earnings can grow at least in line with long-term global GDP potential growth rates of 4.2% in real terms; add to this the global inflation expectations of 3.8%, and I am looking for very long-term earnings growth of 8%. Because of excess capacity in the industry and because there is a glut in the iron-ore market, I expect nominal growth to be somewhat slower: the expansion in earnings will be driven by volume, not necessarily margin or price. In nominal terms, for the steel industry, I would look for growth of at least 4%, with a long-term return on equity potential of 10%. To sustain growth at 4%, the company would need to reinvest (Note 3) 40% of earnings, with the remaining 60% being available to shareholders. An investor seeking long-term return of 13% (Note 1) for a stock growing earnings at an annualized rate of 4%, at a time when earnings are at the target of $5.88 in some years is $41 (Note 2). If I can grow my capital 240% (Target Price/Recent Price = $41/$17=2.41) over the next three to five years, I'd consider this long position a success.
I believe $41 is a realistic long-term target price. However, the steel industry is prone to mispricing: at its 2008 peak, ArcelorMittal traded at $104, which was a multiple of 14 times its 2007 earnings. A recurrence of such multiples would take the price to $82, assuming the adjusted peak earnings target of $5.88 is met. While I do not expect this multiple to occur, a potential next price peak of $73 is very possible - such a target would be realized if investors dropped long-term return expectations to 9% from the beta priced return expectation of 13%. One game plan might be to book profits if the $41 target is achieved and let the original invested capital ride for a target of $73. And then remember to stop running - the race will be done.
(1) The Nominal Investor Return Expectation is calculated as Risk-Free Rate + Beta * (Market Return - Risk Free Rate). I have assumed the risk-free rate is presently at 3%, which is the level at which 10-year government bonds traded recently. The market return over the very long-term has been 9%. Thus, for MT the investor return expectation is 3% + 1.66*(9%-3%) = 12.96% or 13%.
(2) The Target Price (Present Value) is calculated as Adjusted Peak Earnings (1+ Growth Rate) * (1-Re-investment Rate)/(Nominal Investor Return Expectation - Growth Expectation). So, for MT it is $5.88 *(1+4%)* (1-40%)/(13%-4%)=$40.77, or $41.
(3) The Re-investment Rate is the Growth Rate/Return on Equity. For example, if a person has a return on equity of 10% and earns $100, if he or she wishes to grow 6.5%, he or she would need to re-invest $65 at the 10% return on equity to generate the 6.5% growth.