Risky Business, or "How to Invest in Steel"

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Basic materials are often one of the riskiest stocks to invest in. In iron & steel, there are several problems: overcapacity, price volatility, labor unrest, and political uncertainty. Several large producers have fallen to their knees from the financial crisis, and, unlike many of the top companies elsewhere, some have even fallen again. Is now the time to take advantage of low prices? Or should we expect continued problems in the near future? This and more, below.

Why Gerdau (NYSE: GGB) Is Risky

In a recent study, Gerdau (NYSE: GGB) was given an incredibly weak score of 1 out of 10. The company was tested for growth, margins, opportunities, balance sheet, valuation, and dividend. It scored 1-year growth of 11.5% and 5-year annual revenue growth of just 5.6%. Despite poor returns, it didn't pay out much to shareholders; the dividend yield is currently at 1.6% and has actually declined by 10% over the past five years. The one good thing about the company came in the balance sheet, where Gerdau had a healthy current ratio of 2.2x.

There are several specific issues that I see with the Brazilian steel producer. China is getting more aggressive on pricing at a time when input costs and overcapacity are already cutting into margins. Brazilian steel is highly volatile, and production fell 6.3% y-o-y in August just from this concern.  The country's central bank's decision to prop up the economy through monetary stimulus has also led to more inflation than expected at 5.3%, and any attempt to lower inflation would put pressure on the nation's steel industry.

On the positive side, the company is known for being very environmentally friendly, which makes it less of a regulatory target. GGB earned one of the highest possible certificates for its mill in Midlothian: the ISO 14001:2004. For a company to get such a high certificate it first needs to demonstrate its ability to control the environmental impact caused by its activities. At only 8x forward earnings, the stock is also fairly cheap. It has roughly double the volatility of the broader market, so invest only with caution.

Avoid US Steel (NYSE: X), Buy This Stock Instead

US Steel (NYSE: X) is trying to keep its trend of flat-rate prices for its long-steel products, which are currently at $385 per long-ton, despite rising cost pressures. It debuted 2013 with an excellent start, as shares rose 8.5% into the New Year. 11 of 16 reporting analysts, however, are hesitant on the stock and rate it a "hold" or worse. This is despite the price/book ratio being 25% less than the industry average at 0.9x. The pessimism, I believe, is ultimately backed by a very poor 1.1% return on invested capital.

Since companies are ultimately valued based on the future, it is important to look at the growth curve ahead. US Steel is forecast only a modest 5% annual growth rate over the next five years. In my view, however, if you wanted to go for a beaten down and risky stock, ArcelorMittal (NYSE: MT) is one of the more ideal investments. It trades at only 0.5x book value, offers an incredible 4.3% dividend yield, and is forecast double-digit EPS growth over the next five years. It has a beta of 2.1, which indicates the stock has more than double the volatility of the broader market, but the majority of analysts rate the stock a "buy". In my view, the company could be better than just a "buy" for institutions--it could be an outright industry takeover. The firm is heavily debt-loaded right now and not in a strong position to negotiate. Since steel production is scalable, an acquisition would generate meaningful synergies to create value after interest expenses were paid.

TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool owns shares of ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

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