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The steel sector has taken a massive beating over the past two years and while it might appear to be a good time to jump in from a contrarian perspective, investors should tread with caution. If you are going to take a position, make sure you have a long-term investment horizon in the order of at least several years. It would also not hurt to take small bites, as opposed to taking a huge position in one shot.

According to the World Steel Association, global steel consumption growth is forecast to slow down to 3.6% in 2012 from 5.6% in 2011. In part, this is due to weakening demand from China and the debt crisis that continues to plague the eurozone.

While demand in China has been dropping, steel usage in 2013 is still projected to increase to 675 million tons, an increase of 61% in comparison to 2007 figures. In 2012, China's steel usage is expected to increase by 4% to 649 million tons, compared to an increase of 6.2% in 2011. However, on a yearly basis, growth is dropping. In 2011, demand grew by 6.2%; in 2012, it is projected to grow by 4%; and, in 2013, it's projected to grow again by another 4%.

Prior to stating that demand would slow down, the world steel organization actually stated that global demand would grow by 5.4% back in February. Thus, these projections should be taken with a grain of salt. The developing world still has many large infrastructure projects that need to be completed. The economic crisis might slow down things for a while, but these countries (especially China and India) can only put these projects on hold for so long.

India's power grid is in sore need of an upgrade. The latest power outage in India, which affected over 600 million people, is something that needs to be addressed soon. According to the Asian development bank's estimate, Asian economies need to invest about $8-trillion in infrastructure in the next 10 years. Thus despite the somewhat sour outlook for the steel sector, taking a small position in this sector could prove to be a good long-term investment.

If you are willing to take a bit of risk consider taking small positions in one of the following three companies, Nucor Corporation (NUE), United States Steel Corporation (X), ArcelorMittal (MT). Our play of choice is ArcelorMittal, and we are going to employ a strategy of selling puts to try to get into this stock at a much better price.

Some reasons to be bullish on ArcelorMittal :

  • A decent yield of 4.40%
  • A levered free cash flow of $4.98 billion
  • A current ratio of 1.4
  • A good free cash flow yield of 12.7%
  • Analysts have a median price target of $23.59 on the firm.
  • A long-term debt to equity ratio of 0.40
  • Projected year over year growth rate of 79.3% for 2013, according to dailyfiance.com
  • Sales increased from $65 billion in 2009 to $93.9 billion in 2011
  • Net income rose from $75 million in 2009 to $2.25 billion in 2011
  • EBITDA increased from $1.02 billion in 2009 to $9.2 billion in 2011
  • Cash flow per share increased from $4.88 in 2009 to $5.04 in 2011
  • A high beta of 2.62 which makes it a good candidate for selling options. Stocks with higher beta's command higher premiums.
  • It has an estimated 3-5 year EPS growth rate of 21%, according to Zacks.
  • Zack's has earnings per share estimate of $2.45 for 2013, which represents a significant increase over its 2012 estimate of $1.14.

Click to enlarge

Reasons to be cautious

The world economy is not in the best of shape. The euro crisis, China's slowing economy, and excess supply of steel in the U.S. could continue to have a negative impact on the company's earning power.

It missed revenue expectations in the second quarter. Due to declining demand, it had to shut down some facilities in Europe and the oversupply of steel in U.S.A did not help the situation. EBITDA declined 28% year over year to $2.5 billion.

Technical outlook

After putting in a high of $104 in June of 2008, the stock has been in a free fall. It is currently trading slightly off of its 52-week low of $13.28 set in June 2012. At the same time, it appears to be attempting to put in a bottom. As long as it does not close below $13.28 on a weekly basis, the outlook will remain neutral. A weekly close above $15.50 will turn the short-term outlook to bullish. From a long-term perspective, it could make for a good play, as it has taken a massive beating, and the worst news appears to be priced in the stock. However, from a short-term perspective, the stock could potentially drop down to the $12.50-13.00 ranges (at least on an intra-day basis) before trending higher. In such situations, if one is willing to take a bit of risk, the best option is to usually sell puts. Selling puts is a great way to purchase shares in companies you like at a predetermined price. In essence, you are getting paid to put in a "limit order."

Suggested Strategy for ArcelorMittal

An investor usually sells a put option if his/her outlook on the underlying security is bullish. The buyer of the put option pays the seller a premium for the right to sell the shares at an agreed-upon price. If the stock does not trade at or below the agreed-upon price (strike price), the seller gets to keep the premium.

Benefits associated with selling puts

  1. In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.
  2. It allows one to generate income in a neutral or rising market.
  3. When you sell a naked put, you are in a way acting like an insurance agent. The Seller of the option agrees to buy the stock in the future if it drops to a certain level before the option expires. For this, you (the seller) are paid a premium upfront. If this strategy is repeated over and over again, these premiums can really help boost your returns over time.
  4. Acquiring stocks via short puts is a widely used strategy by many retail traders and is considered to be one of the most conservative option strategies. This strategy is very similar to the covered call strategy.
  5. The safest option is to make sure the put is "cash secured." This simply means that you have enough cash in the account to purchase that specific stock if it trades below the strike price. Your final price would be a tad lower when you add the premium you were paid upfront into the equation. For example, if you sold a Seadrill Limited (SDRL) Jan 2013,39.65 put for $2.95. If the shares were assigned to your account, your final price would be $37.15 after the premium was factored in.
  6. Most put options expire worthless and time is on your side. Every day you profit via time decay as long as the stock price does not drop significantly. In the event it does drop below the strike you sold the put at, you get to buy a stock you like at the price you wanted. Time decay is the greatest in the front month.

The Jan 2013, 13 puts are trading in the $1.14-$1.17 ranges. If the stock pulls back to the 12.50-13.20 ranges, these puts should at least trade in the $1.50-$1.60 ranges. For this example, we will assume that the puts can be sold at $1.50

Advantages and disadvantages of this strategy

The main benefit is that it provides the investor with the opportunity of getting into this stock at a predetermined price. Unlike a limit order, you get to apply the premium towards your cost, which means your final price will be below the strike price you sold the puts at.

Secondly, if the stock does not trade below the strike price, then you at least get paid for your time, unlike a limit order which either gets filled or cancelled. If the shares are not assigned to your account, you walk away with a gain of roughly 13% in 6 months. If the shares are assigned to your account, your final cost will be $11.50.

In terms of risk, you are taking on the same level of risk as you would if you purchased the shares outright, but with the added benefit of getting in at a lower price (via the premium you received). If you have a change of heart and feel that the stock could trade well below the strike you sold the puts at, you can always roll the put. Buy back the puts you sold and sell new out of the money puts.

Conclusion

At this point, as the outlook for the steel sector is not that rosy, only contrarian investors or those willing to take on a bit of a risk should consider putting this strategy to use. However, as this stock has taken such a beating, it could prove to be very rewarding investment in the years to come.

Options tables sourced from yahoofinance.com. Zack's consensus estimates sourced from zacks.com

Disclaimer: It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies - let the buyer beware.

Source: ArcelorMittal: An Opportunity To Get In At $11.50 Or Earn 13% In 6 Months