Part of the glory in being a speculative investor comes from generating higher risk-adjusted returns. Ever since the Modern Portfolio Theory emerged, financial economists have generally agreed that higher beta stocks generate higher returns. This makes sense, because investors will be more averse to backing future streams of free cash flow based on past volatility. This "risk aversion" carries through into higher discount rates that reduce valuation. In the long-run, however, risk aversion undermines normalized returns and thus undervalues certain businesses, even sectors. Steel is one such sector that is heavily discounted below intrinsic value. From high volatility to leverage concerns, steel is highly risky. However, in the four tickers below, I demonstrate that reward outweighs risk.
AK Steel (AKS)
AK Steel trades at 5.9x forward earnings with an impressive dividend yield of 3.2%. Consensus estimates forecast the company's EPS turning positive in 2012 at $0.37 and then hitting $1.35 in 2015. Assuming a multiple of 9x and a conservative 2013 EPS of $1.05, the stock will hit $9.45 for more than 50% upside. With a beta of 2.5, the stock is will positioned to recover much of the lost shareholder value since last January.
Even still, the Street remains mostly reserved on the stock. According to NASDAQ, analysts rate the company around a "hold" and revisions to EPS have fallen for a net change of -6.4%. Sovereign debt crises and sluggish economic growth only add to the list of woes. Ultimately, however, I believe that the risk is worth the reward. Construction is starting to improve and is currently trading well below historical multiple levels. SG&A costs are also proportionally declining due to improvements in labor management.
Gerdau trades at a respective 14x and 4.4x past and forward earnings with a dividend yield of 2.7%. Consensus estimates for Gerdau's EPS forecast that it will grow by 12.3% to $1.37 in 2012 and then by 62% and 17.6% in the following two years. Assuming a multiple of 8x and a conservative 2013 EPS of $2.18, the stock would hit $17.44. This is a staggering amount of upside and easily makes it worth the risk.
Institutional investors are shrugging Gerdau given that they own just 12% of the outstanding shares. With that said, the firm is attractive given its emerging market focus and the fact that it is trading meaningfully below its 52-week low.
ArcelorMittal trades at a respective 30.8x and 5.1x past and forward earnings with a dividend yield of 5%. To value the company, I employ a DCF model. In this model, I make several assumptions: (1) 25.1% per annum growth over the next half decade or so, (2) operating metrics stay out historical levels, and (3) net increases in working capital hovering around 0.5% of revenue. I find that the company generates enough free cash flow within just 13 quarter to exceed its market value. This is substantially cheaper than peers.
Not surprisingly, the Street is also optimistic about the company. According to NASDAQ, the stock is rated a "strong buy" and has a price starlet of $27.58. Considering that the firm offers an amazing 5% dividend yield on top of this upside, it will suffice to say that risk/rewards is very compelling.
Nucor trades at a respective 14.6x and 9.4x past and forward earnings with a dividend yield of 4.2%. Consensus estimates forecast Nucor's EPS falling by 1.7% to $2.35 in 2012 and then growing by 57.9% and 21.3% in the following two years. Of the 21 revisions to EPS, all but one has fallen for a net change of -13.9%.
With the bar set very low for Nucor, high risk-adjusted returns are likely to follow from a quicker-than-expected recovery. While I believe the firm has less attractive risk/reward than ArcelorMittal does, I still am attracted to the management team and 4.2% dividend yield. Unlike Gerdau and ArcelorMittal, Nucor is an American company where labor costs and regulations are particularly high in the steel industry. Past bankruptcies of other American steel manufacturers will keep future streams of free cash flow heavily discounted against emerging market steel manufacturers.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.