Steel industry icon United States Steel (X -0.90%) reported second-quarter 2021 adjusted earnings of $3.24 per share, up from a loss of $2.67 per share in the same period in 2020. The rest of the year is likely to be strong, too. It's little wonder that the stock has rallied nearly 300% over the past year. However, now isn't the right time to buy shares of United States Steel...or those of any of the major U.S. steelmakers, for that matter. Here's what you need to understand before you fall in love with steel today.
The dynamics that matter
U.S. Steel isn't alone in posting stellar results. Industry giant Nucor (NUE 0.31%) reported record earnings in the second quarter. Fellow electric arc mini-mill specialist Steel Dynamics (STLD 0.61%) also hit a record. And so did blast furnace-focused Cleveland Cliffs (CLF -0.10%). The entire U.S. steel industry is firing on all cylinders today.
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However, that's pretty much how the industry generally works. When steel is in high demand, the steel mills cash in. But steel is a cyclical sector, and eventually, demand will cool off, pricing will weaken, and results will fall. When that happens, investors tend to dump the shares of the major U.S. mills. The ups and downs here generally follow along with economic activity, since steel is a key material for construction, auto manufacturing, and a host of durable products that are expensive and have long useful lives. These are the types of things that people buy when times are good, but pull back on when times are tough.
It's actually a fairly predictable relationship that investors need to keep in mind when looking at steel stocks. If you buy during the peak of the cycle, you will likely end up paying a premium. And you will certainly pay more than you would if you bought during the trough. Of course, it can be hard to buy stocks when they are unloved. In this case, however, that's the right time to put your money to work. The big takeaway here is that times are good today, Wall Street is enamored with steel stocks, and you should probably be sitting on the sidelines.
One more wrinkle
There's another important issue to keep in mind here, too. As noted above, Nucor and Steel Dynamics use electric arc mini-mills. Cleveland Cliffs and U.S. Steel rely more heavily on blast furnaces. These are two very different technologies that produce very different financial results. Blast furnaces have high operating costs and need to be run at high utilization rates to make money. But once the mills cover their base costs, they tend to be very profitable. Electric arc mills are smaller and more flexible, so output can better adjust to the ups and downs of demand. They don't make as much money during the good times, but they don't bleed red ink as readily as blast furnaces when demand falls off. All told, electric arc mill performance is more stable over time.
That helps explain why shares of Cleveland Cliffs and U.S. Steel are up around 380% and 300%, respectively, over the past year while shares of Nucor and Steel Dynamics are "only" up about 150% and 135%, respectively. The risk inherent in this disparate performance is that when the cycle turns down again, shares of Cleveland Cliffs and U.S. Steel are likely to fall much harder than those of Nucor and Steel Dynamics. So there's a double layer of risk here if you decide to buy the best-performing steel stocks during an industry upturn.
Wall Street falls in love with steel stocks when performance is good and typically favors the names showing the most dramatic earnings improvement. While that makes sense, it doesn't account for the basic nature of the industry in which good times are invariably followed by bad times (it's highly unlikely that this cycle is going to be different). Investors need to recognize the ups and downs here and incorporate that into their investment thesis. In other words, now is a terrible time to buy a steel stock for the long term.
The better way to play steel
For long-term investors, the best way to approach the steel sector is probably to stick with the more stable performance of electric arc mini-mill owners Nucor and Steel Dynamics. It's also best to buy them when the broader steel industry is out of favor. That time isn't now, but if you are patient, the cycle will eventually give you a chance to jump aboard here. Put simply, Nucor and Steel Dynamics belong on your wish list, not your buy list, today.
