This Stock Is Too Cheap to Ignore

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

Whenever investors fear economic weakness, the stocks they flee first tend to be in cyclical industries that are also capital-intensive. Likewise, investors tend to return to these stocks last as the economy recovers. Such is the case in the steel industry, where ArcelorMittal (NYSE: MT) cannot seem to catch a bid in the current bull market.

Bleak short-term outlook

There are countless companies that seem cheap, but many have competitive situations that make their futures difficult to ascertain. As a company whose profits are dictated by the market price of a commodity product, ArcelorMittal is hardly in control of its own future.

However, as the largest steel producer in the world, the company's prospects are significantly better than its competitors. As a result, the company is likely to perform much better than its peers when the inevitable upswing in steel prices comes to fruition.

The stock trades for just 40% of book value, but not without reason. ArcelorMittal's profitability has evaporated due to plunging steel prices caused by low economic activity in Western Europe and throughout the developed world.

Meanwhile, emerging economies -- especially China -- are ramping up steel production to supply their fast-growing economies. This will add even more supply to a market that already has a lot more sellers than buyers.

Always look at the big picture

Of course, the market is all too aware of these headwinds. David Dreman, the famous contrarian investor, frequently points out that investors are too focused on the last data point. Instead, Dreman says investors should focus on the big picture -- what the company has done over many years, not just what happened last year.

Investors who look at ArcelorMittal's long-term operating history will find that a 7% to 8% return on equity is a conservative estimate of the company's normal earning power. A company that consistently earns an 8% return on equity should trade at least 80% of book value -- roughly double what the stock trades for now.

ArcelorMittal does not earn anything close to an 8% return on equity today, but there is reason to believe that it will do so again in the future. Besides a rebound in steel prices, the company's competitive position will allow it to return to higher profitability.

As the largest company in an industry where scale is the primary competitive advantage, ArcelorMittal has an enormous advantage over other companies. United States Steel Corporation (NYSE: X), for example, cannot export steel to international markets as cheaply as ArcelorMittal because its operations are concentrated within the continental United States.

United States Steel makes up for its disadvantage in scale by owning and operating many of the mines from which it buys raw materials. This puts it on even footing with ArcelorMittal as far as international margins are concern, but ArcelorMittal is still able to produce and deliver larger quantities in a shorter amount of time than its U.S.-based counterpart, giving it a slight advantage in international markets.

ArcelorMittal's primary weakness is its balance sheet. Competitors, like Nucor (NYSE: NUE), have far healthier balance sheets than the company, which affords them a great deal of flexibility during downturns.

The advantage of a strong balance sheet is evident in Nucor's recent activity and plans for the future. While ArcelorMittal struggles to avoid breaching its debt covenants, Nucor is on the hunt for acquisitions. The company can both pick up market share and become a fully-vertically-integrated steel producer.

The acquisition of a scrap processing business has already allowed Nucor to improve its competitive position during the current downturn, and it will likely add other businesses to its portfolio in the near future.

However, with only $18 billion in revenues over the last four quarters, Nucor's operations are only a fraction of ArcelorMittal's $81 billion business. As a result, the company does not pose a significant threat to the latter's market share.

Bottom line

ArcelorMittal is the largest company in an industry where scale is the primary competitive advantage. Steel prices are in the dumps right now, but ArcelorMittal has most to gain when they finally turn up again. At less than half of book value, the stock is too cheap for long-term investors to ignore.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Nucor. 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. Think you can do better? Join us and write your own!

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