Valuing the iron and steel sector these days probably should place greater value on those companies which are U.S. based, as the weakening U.S. dollar will cause these companies to see higher rates of growth than foreign competitors. There is a case to be made for European Union companies as well, for the same reasons. The justification for this is that the revaluation of the Chinese Yuan and the U.S. dollar is resulting in a reversal of the U.S. trade deficit. The charts below show that the U.S. trade deficit with China and Japan respectively are definitely reversing, confirmed by the polynomial moving averages shown.
For that reason, I truly believe higher valuations should be given to U.S. iron and steel producers versus the average world industry valuation, because the world will eventually be forced to buy U.S. products due to their cheap cost for the rest of the world, especially China.
Miners in countries like China are propped up with artificial tariffs to protect their trade from this development-- for example, an 18% import tariff exists on Chinese coal imports.
Additionally, many countries, including China, have artificially low currency values which boost their mining company profits. Chinese miners in particular are extremely vulnerable to losing the ability to grow profits due to the revaluation of the Yuan which is taking place.
With all that said, I will use the following index to attempt to price in the future better than the market is. I will average P/Cash Flow ratios and Price/Sales ratios to create a balanced index. Additionally, I will penalize Chinese miners the most, and boost American companies. Most other countries have a much less predictable currency situation, but the safe assumption is the U.S. dollar will continue to be weaker than average. So I will multiply Chinese companies by a factor of 1.25, U.S. companies by 0.75, and so on to help better incorporate each company's respective currency-related expected performance / valuation.
One could argue quite well that the market already incorporates all of these types of issues into the price of stocks, so my factoring won't be necessary. I would argue that the market is not entirely efficient based on an information asymmetry, in this case ignorance of world currency moves. In fact, I'd venture the average analyst does not incorporate this information into their analysis because they are totally oblivious to this reality. Nevertheless, I will include two index rankings, one which uses my valuation index and one which doesn't use my factoring, for those interested.
The stocks at the top of the table represent the stocks which are the cheapest after adjusting for further expected currency revaluations. The magnitude is not something I can calculate exactly, but the main point does come across well. The stocks at the bottom of the table represent the most overvalued companies in the sector.
|Ticker Symbol||Company||Country||Factor||Price/CF||Price/Sales||Index||Currency-Adjusted Index|
|CHOP||China Gerui Adv Mtals||China||1.25||4.1||0.7||2.4||3.00|
|SMS||Sims Metal Management||Diversified||1.05||12.4||0.4||6.4||6.72|
US Steel demonstrates that my theory is already being priced in fairly well by the market. Because U.S. steel is based so heavily in the U.S. and has such a recognizable name, and because it has such high volume and market cap, most equity funds really need to add U.S. steel to their portfolios. In other words, they in some cases cannot add much (NASDAQ:SCHN), (NASDAQ:STLD) , (NYSE:WOR), (NASDAQ:USAP), or (NYSE:CMC), because the funds would then own too much of the individual company to satisfy diversification standards the fund abides by. This creates opportunity for smaller investors to buy smaller U.S. based companies. Funds may slowly rebalance out of US Steel and into Nucor (NYSE:NUE), due to its great market cap and volume and more attractive fundamentals.
If one looks at the performance of the Chinese based companies in the sector, one finds my theory of currency-forecasted growth to be the number one indicator of equity performance. These companies have all been plunging of late, along with the revaluation of the Chinese Yuan. The relationship can be seen below. It seems that many funds couldn't resist and have already jumped on this defenseless group of equities. The Yuan has risen only slightly over the last three years, but if observed closely, the relationship between Chinese mining companies becomes clear. Small moves in the Yuan are resulting in near bankruptcy for these firms. The Yuan appreciation versus the dollar can be seen below in black compared to the Chinese iron and steel companies (NASDAQ:SUTR), (NASDAQ:OSN), (NASDAQ:CHOP), and (NASDAQ:CPSL).
Click to enlarge
The question to ask is -- have these Chinese equities been sold off too hard? My results suggest that they have, although not greatly. Much depends on how quickly the Chinese revalue the Yuan though.
You may have heard Jim Rogers recently speak about being short emerging markets. It is my theory that he is short almost entirely emerging market commodity-related stocks, not other industries, and long U.S. based commodities. This results in much more stable returns on commodity-based returns.
My valuation of the sector attempts to make profits on small inefficiencies in valuation when using expected currency moves. Buying and selling the stocks as individual investments will likely not work unless some kind of bubble or crash develops. Making a bet spread out across the entire sector should prove to exploit some inefficiencies though.
In conclusion, at the very least, following the currency markets can greatly help one see the behavior of international versus domestic equities, and may help exploit industry inefficiencies. It is clear the market is to some extent anticipating major profit growth for U.S. based iron and steel companies, best illustrated by US Steel. The market also appears to believe that the Chinese based companies are going to experience somewhat of a crash in profits once the Yuan rises a bit further.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.