A big dilemma for many investors is whether to own steel stocks in a long-term portfolio. The US steel industry has been plagued by inefficient technology, oversupply and bankruptcies for many years. Just as oversupply was dealt with using the various (and sometimes crude) mechanisms of the free market, the industry caught the triple whammy of a steel tariff, increased demand from emerging markets (led by China) and economic growth in all major industrialized nations, a confluence of events not seen in 30 years.

And steel stocks ran and ran and ran from 2002 lows. Just as other commodity stocks coming off a major bottom, the worse shape the company was in the higher its stock went. Lower-quality steel stocks increased more than five-fold in some cases, while higher quality stocks doubled and tripled.

One rule of thumb when buying commodity stocks, be they steel producers, nickel or copper mines, or any other kind, is to buy them when they look expensive and sell them when they look cheap.

Let us elaborate.

When commodity prices are depressed commodity stocks have little in the way of earnings. Their P/E ratios (the most popular, but over-hyped and sometimes misused, measure of stock value) are very high because of that lack of earnings. This is where the stocks sit at the bottom of the cycle: expensive and hated.

On the other hand, near the top their earnings have skyrocketed due to the operational leverage of their profit-and-loss statements, their P/E ratios are low and the stocks are cheap. Investors see nothing but blue skies, forgetting that economies go through cycles. We never bought the idea of a “New Economy” void of cycles. Steel stocks as a group always suffer vicious selloffs when the economic cycle peaks. This should help you remember to sell when you have big gains on a steel stock.

One US steel company with a great history of sector outperformance is Nucor (NYSE: NUE). The company traces its roots to the founder of Oldsmobile and experienced many transformations becoming the biggest steel producer in the US. Nucor had its problems in the 1960s, but it learned from them and invested heavily in low-cost steel technologies which allowed it to make money while so many of its archrivals went bankrupt in the 1990s.

Asian steel producers are much closer to the center of the most promising economic region in the world economy today. A standout is Korea-based POSCO (NYSE: PKX); its present name is the acronym for Pohang Iron and Steel, the original name of the company.

POSCO’s operations cover the majority of main steel products. But it is also one of the world’s most advanced producers, specializing in high-value products like hot-rolled and cold-rolled steel, plates, wire rods, silicon steel sheets, and stainless steel. The value is in the company’s cost effectiveness and leverage to the economic development of both India and China. In 2005 POSCO signed a contract for the biggest (not only the company’s history, but also in the history of South Korea) integrated steel production facility in to be built in the economically underdeveloped but resource-rich Indian state of Orissa. Although a slowdown in the global economy will undoubtedly affect a global player like POSCO, the inroads the company has made in China and India--as well as its exposure to more profitable higher-end steel products--make it a prime long-term portfolio holding.

Another interesting is India-based Tata Iron and Steel (India: TISCO). Since the Indian economy is the most domestically oriented in Asia, global economic cycles tend to have a lesser affect on domestic producers. India lags China in infrastructure development, but is likely to catch up fast. Indian steel producers targeting the local economy stand to benefit.

Trying to pick a stock investment in every industrial metal is an exercise in futility; it can be done, but in the end one will end up with too many mining shares for most individual investors’ portfolio size. Investors should pay attention to two mining conglomerates that cover a wide spectrum of industrial metals and energy, BHP Billiton (NYSE: BHP) and Rio Tinto (NYSE: RTP).

Every major specialized mining conglomerate like Phelps Dodge or INCO has operations in other metals, most of them due to residual products left from the mining of their primary specially products. But there is no match in the industrialized world for diversified mining conglomerates like BHP Billiton and Rio Tinto. The two companies differ enough that they make great choices for coincident exposure to a wide array of industrial metals and energy.

BHP Billiton is the result of the 1997 merger of UK-based Billiton PLC and Australia’s Broken Hill Proprietary. The Billiton side of the company had primarily diversified mining operations while the BHP side had, in addition to the metals, large exposure to oils, natural gas, and coal. BHP Billiton is dual-listed in London and Sydney, with the two companies operating as separate entities but with identical boards of directors and a unified management team. Shareholders in each company have equivalent economic and voting rights in the BHP Billiton Group as a whole. Investors who buy BHP through the NYSE-listed American Depositary Receipt circumvent the complexity of dual shareholding.

Rio Tinto is about half the size of BHP and it does not have any meaningful oil exposure. For investors already heavily overweight energy stocks, Rio Tinto may be the better choice. To diversify company-specific risk and gain broad exposure in the metals and mining space, both stocks are recommended. Increased crude oil exposure would only help future performance.

© 2006 Yiannis G. Mostrous
Editorial Archive

The preceding is an excerpt from The Silk Road to Riches: How You Can Profit By Investing In Asia’s Newfound Prosperity, published by Financial Times/Prentice Hall. The Silk Road to Riches is available at Amazon.com and in a bookstore near you.

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