1 Steel Stock I'm Buying Today

This article is part of our Rising Star Portfolios series.

The past few months have not been kind to cyclical companies, which tend to be very sensitive to the economic cycle. These stocks tend to rise very strongly in cheery times and fall hard when investors get skittish. Due to ongoing concerns about Europe's debt crisis and a potential Chinese slowdown, some of these companies have fallen as much as 50% from 52-week highs, creating potential bargains for investors.

One beaten down company that keeps popping up on my radar is ArcelorMittal (NYSE: MT), the largest steel producer in the world. The stock hit a 52-week high of $38.88 earlier this year before falling almost 50% to today's price. To a bargain hunter, there is nothing sweeter than a faltering stock price. At Monday's closing price of $20.43, ArcelorMittal trades at just half of book value, much less than it did in earlier months.

Steel consumption still rising
Despite the current economic backdrop, steel production continues to climb steadily. According to The World Steel Association, steel usage will increase by 6.5% in 2011 and 5.4% in 2012. Steel production is significant because it is tied to automobiles, construction, appliances, machinery, and many other things that drive economic activity.

Despite the growth in steel demand, my feeling is that we're at least a year or two away from major economic recovery. Unemployment is still very high and many aspects of our economy have yet to come anywhere close to pre-crisis levels. These are likely to recover slowly at best. However, markets are forward looking. This means that the best time to buy steel producers is when the outlook doesn't look so rosy.

The business
ArcelorMittal was formed in 2006 by a merger of equals between Arcelor and Mittal Steel and is led by Chief Executive Lakshmi Mittal, who owns 41% of the outstanding shares. The company has an annual production capacity of 130 million metric tons, dwarfing the capacity of the next biggest competitor. ArcelorMittal's competitive strategy is threefold: Emphasize geographical diversification; emphasize product diversification; achieve upstream and downstream integration.

1.Geographical diversification: The company believes it is very important to be a market leader in each region in which it competes. ArcelorMittal produces steel out of 20 countries on four continents. In 2010, the company produced 36% of its steel in the Americas, 53% in Europe, and 11% in other countries. In addition to these areas, the company is steadily building its presence in China and India.

2. Product diversification: ArcelorMittal has a large presence in its markets, so it tailors its products accordingly. Developed markets tend toward more finished and value-added products, while emerging markets have different preferences. In either case, the company believes it's important to achieve size and scale in each market in order to maximize production efficiencies.

3. Upstream and downstream integration: When companies make steel, they require large amounts of raw materials, including iron ore and coal. In 2010, ArcelorMittal sourced 56% of its own iron ore, 15% of its own coal, and 44% of its own scrap steel. The mining business is up roughly 10% in 2011, but the company hopes to improve on this in coming years. It has several projects that it hopes will further expand capacity. The company is already performing well on this front: it is already the number four iron ore producer in the world behind mining giants Vale (NYSE: VALE), BHP Billiton (NYSE: BHP), and Rio Tinto (NYSE: RIO).

In addition to being more self-sufficient with its upstream operations, ArcelorMittal plans to invest in downstream operations such as steel service centers and building and construction support services. By gradually controlling more of its value chain over time, the company hopes to get closer to the customer and to reduce cyclicality in its business.

Now that we know a little about ArcelorMittal, let's see how it stacks up against some of its peers:

Sources: S&P Capital IQ and The World Steel Association.

The table shows that ArcelorMittal is the cheapest of the bunch at only 8.5 times expected 2011 earnings and half of book value. During the boom years from 2003 to 2007, ArcelorMittal traded at an average of over two times book value. If the company were to recover just 75% of book value -- which is not asking a whole lot -- it would be worth $29.50 per share. Using an earnings approach, applying a 10-times multiple to FY 2012 earnings gets us to $30.20 per share. At about $20 a share, this company looks like a potential bargain.

The four companies I listed would be my candidates from which I would choose if I bought a steel stock. Nucor is very well-run and has the least amount of debt, and POSCO is also well-run and quite cheap. US Steel has the most speculative upside, with the lowest price/sales ratio and the number of dollars paid per ton of steel production. However, with its scale, vertical integration, and cheap valuation relative to that of its peers, my favorite is ArcelorMittal.

Unfortunately, investing in a steel company is not without its risks. An unfavorable event in the European debt crisis or a Chinese slowdown could cause the stock's price to fall even further in the face of slowing demand. Also, the company carries quite a bit of debt. The company has a reasonably strong liquidity position, with $2.8 billion in cash, $20 billion in long-term investments, and $10 billion in available bank credit. Steel production is on track to grow this year and next, but a macroeconomic shock would still hurt quite badly.

Foolish bottom line
There are plenty of reasons to be scared of steel companies at the moment, but I believe that has been more than reflected in the stock price of ArcelorMittal. At the current price, we're getting the opportunity to buy the world's largest steelmaker at just half of book value. I will be adding shares to my portfolio to take advantage.