The S&P 500 Index has roughly doubled since hitting a bear market low on March 23, 2020. The stock price for domestic steelmaker Cleveland-Cliffs (CLF 5.16%) has advanced more than 550% since that same point. Before you get excited about this massive outperformance, you need to understand a few things about the company and the industry in which it operates.
What a show
Cleveland-Cliffs is one of a handful of notable domestic steelmakers, but it wasn't always that way. At one point just a few years ago it was actually just a steel industry supplier, selling iron ore to steel producers. But the company decided it needed to shift gears and become an integrated steelmaker, with operations spanning from mining iron ore to making steel itself.
Image source: Getty Images.
The company bought financially troubled AK Steel, turning itself into an integrated steel company. Shortly after that it added the U.S. steel assets of global steel giant Arcelor-Mittal, quickly making it one of the biggest names in domestic steel. In just a few short years, Cleveland-Cliffs basically transformed itself into a new company.
The timing of this move turned out to be pretty good since the steel industry has rallied massively. As noted in the intro, looking back to the end of the 2020 pandemic-related bear market, Cleveland-Cliffs' stock is up more than 550%, easily trouncing the S&P 500 Index's gains. But it has also easily outdistanced the rest of the major North American steelmakers, as the chart below shows. Iconic United States Steel (X +0.00%) is the industry's next-best performer, with a gain of around 300% over that same span.
X data by YCharts
The stock really has put up an impressive showing. But there's more to understand here than just how well the stock has done.
Is now the time to buy?
For starters, the steel industry is highly cyclical. That basically means that steel stocks tend to rise and fall along with the economy. Big changes in capital spending, like those proposed by the recently signed infrastructure package, can be major tailwinds, as such investments generally require massive amounts of steel. Given the economic upturn since the coronavirus-related economic shutdowns and the new infrastructure spending that is on the horizon, you can understand why investors would like steel stocks.
The problem is that Wall Street tends to be forward-looking, and often prices in a lot of good news during upturns. When the industry inevitably slows down, investors often just run for the hills, leading to material underperformance. If you look at the performance of industry peers U.S. Steel, Steel Dynamics, and domestic bellwether Nucor (NUE 1.44%) through the 2007-to-2009 recession you can see exactly how dramatic the ups and downs can be.
X data by YCharts
With Cleveland-Cliffs and the rest of the steel industry in a clear upturn now, the risk is really to the downside. All it will take is for the economy to start slowing down and investors are likely to start exiting the stock in large numbers. It's just how the industry works.
A part of the problem with Cleveland-Cliffs is that it uses blast furnaces, which are expensive to operate and need to run at high capacity levels to be profitable. They are very profitable when they are well used, but when demand falls off these mills can quickly become unprofitable. U.S. Steel is also a major blast furnace user, and its profit margins versus Nucor, which uses more modern and flexible electric arc furnaces, are telling. Cleveland-Cliffs' business makeup is more similar to U.S. Steel than to Nucor.
X Profit Margin data by YCharts
So when the next industry downturn comes, which it will eventually, Cleveland-Cliffs could suddenly go from an industry leader to an industry laggard. And the change could take place pretty quickly.
Exciting on the upside, but...
To be fair here, Cleveland-Cliffs as a business will benefit nicely from increased steel demand. Not only from its own mills, but also from those of competitors as they increase their buying of iron ore. So Cleveland-Cliffs is something of a leveraged play on the domestic steel market.
However, before you run out and buy it, make sure you understand that what goes up can also go down. This is not, at least at current prices, a set-it-and-forget-it type investment. No domestic steel mill is right now, but because of the recent changes to Cleveland-Cliffs' business corresponding with an industry upturn, it is really important to make sure you take a big-picture view. Don't get so caught up in the story behind the company's well-timed transformation that you forget the inherently cyclical nature of its business.
