Are Steel Stocks the Ultimate Contrarian Metals Play? (SLX)

For U.S. steel stocks, it’s beginning to feel a bit like déjà vu. More specifically, it’s beginning to feel a whole heck of a lot like 2009.

Are Steel Stocks the Ultimate Contrarian Metals Play? (SLX)
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In almost a repeat of that year, prices for all manners of steel products have cratered in the wake of slowing demand and rising output. Rising supplies and lower demand is never a good thing for any company or for steel stocks.

And like that year, steel stocks have pretty much plunged from their recent highs.

But as it goes on Wall Street, yesterday’s trash could be tomorrow’s superstar. The question for investors now is whether or not the various steel stocks are worth picking up off the floor and placing them in your portfolio.

Steel’s Divergent Viewpoints

After rebounding rather nicely since the end of the recession, last year wasn’t so kind to steel stocks. Rising production from low-cost producers in China and South Korea have flooded the market. China currently produces more than half of the world’s steel supply, but continued to add capacity. During 2014, the nation added more than 20 million metric tons worth of new production to the marketplace.

That rising output has been met with stagnating demand.

China’s steel appetite has diminished as its economic miracle begins to cool off. At a 7% projected GDP growth rate, China is still cranking out more steel that it can even use. And as the largest consumer of the metal, that’s a big problem — a problem that’s compounded further by the rest of the world.

Both the global auto and nonresidential construction industries — two of the largest end-users of steel — still haven’t rebounded to pre-recession highs. Meanwhile, coiled tubing demand has dropped by the wayside as the oil and gas bust has killed demand for drilling pipe and midstream infrastructure.

And while overall global demand for steel has ticked up slightly — due to a relatively strengthening global economy — the sheer glut of cheap steel is still more than the market can handle.

With the supply/demand imbalance in tow, steel’s benchmark hot-rolled coil index has fallen by more than 17% since the beginning of the year and sits near $500 per ton. That’s in line with global steel price averages and is at the lowest price since August 2009.

Needless to say, all of this hasn’t exactly been great for the various steel stocks margins or profits. Or their share prices. The NYSE Arca STEEL Index — which tracks a basket of U.S. steel stocks — is down about 37% over the last 52 weeks.

But there is some glimmer of hope on the horizon that could make the dour situation in the steel sector much brighter.

First, the overcapacity issues may finally be working themselves through. With prices for steel in the toilet, many Chinese mills are teetering on financial collapse. Default risks and bankruptcies have continued to rise over the last year or so. Mill closures will take some of the excess capacity out of the marketplace. Also helping is Beijing’s recent stance to fight the overcapacity and reduce pollution/emissions in the nation.

In North America and Europe, many steel mills have begun to lower capacity or shut down mills indefinitely as prices have become too cheap for profitability. Like the closures in China, these cuts will take some of the bite out of the excess capacity.

On the demand side, India seems to be picking up China’s slack. The election of reformist Prime Minister Narendra Modi has boosted infrastructure spending and investment in the nation. According to Moody’s Investor Services, this surge in infrastructure spending will help grow India’s steel demand by the high single digits this year.

Time To Buy Steel Stocks

In the medium term, the outlook for the steel sector isn’t necessarily so bad. Overall, the capacity overabundance should break as new demand drivers begin to pick up.

The problem is getting to that point. Many analysts still predict that the steel shakeout could be keep going for some time before it finally rebounds.

Investors still have a chance to snag some of the steel stocks on the cheap. And given how bumpy the ride could be, a broad approach could be the best way to get in.

The Market Vectors Steel ETF (NYSEARCA:SLX) is currently the only “pure” way to get your steel exposure. While the ETF does include some coverage to iron ore producers — Vale SA (ADR) (NYSE:VALE) and Rio Tinto plc (ADR) (NYSE:RIO) — SLX its chocked full of global steel stocks, both low-cost companies and specialty producers.

Of the fund’s 29 holdings, roughly 37% are located in the United States. Those stocks have the most to gain as the steel sector finally rebounds. Meanwhile, low-cost producers such as Korea’s POSCO (ADR) (NYSE:PKX) offer a chance to profit from the low steel price environment.

As for value, SLX can currently be had for only a price-to-earnings ratio of 12. That makes the steel industry one of the cheapest sectors around. And while the SLX could drop more over the next few moves as the shakeout persists, that cheapest does provide a margin of safety — much of the worst has already been priced in.

The Bottom Line

The steel stocks are pretty hated right now and there is plenty of reasons why. However, that hatred has made them an interesting bargain versus the rest of the commodities space. And with the near-term picture not so cloudy, they could finally rebound.

The SLX could be the best way to play them.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

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