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.
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).
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.