Back in 2011, my view about the steel industry was pretty simple: Even in an underperforming industry, we should be able to find a company that is capable of outperforming the market. This is a simple argument that justifies the idea of searching for investment targets in depressed cyclical industries. Obviously, when the general economy starts recovering, we expect that the companies in cyclical industries also recover. Based on this idea, I started looking for companies that had an edge over peers in the steel industry.

I found ten companies which seemed fit for further research. Among them were some solid industry names like Tenaris, Salzgitter (NASDAQOTH:SZGPY), Voestalpine, Alcoa (NYSE:AA) (not quite a steel producer but similar economics), ArcelorMittal (NYSE:MT), Nucor (NYSE:NUE), and US Steel (NYSE:X). My choice ended up being a small German steel producer called Salzgitter. My selection was based on some production efficiency metrics that I believed to demonstrate a cost production advantage.

However, my Salzgitter's analysis was flawed by one error that essentially compromised the whole research. I made the mistake of starting by looking at production cost metrics. By doing this, I started with a biased vision almost since the beginning, since I ignored the company's ability to charge premium prices. I still think that Salzgitter is a fairly good steel company. The company is an efficient producer, with focus on process optimization and a good reach in international markets.

However, there is nothing that Salzgitter does that others cannot do with a reasonable effort. The company provides some tailored solutions to some of its clients, but this is only a fraction of the company's main business which is to produce steel for the auto and construction industries and to manufacture steel tubes for infrastructure. The main problem is that, in these lines of business, there are numerous competitors that compete through aggressive pricing.

The company exhibits some tendency to enter adjacent markets like the production of machinery for filling and packaging of beverages, which has been a profitable line of business. However, this unit is still small and I do not foresee a noticeable growth in the medium term, since fueling growth costs money, and the company is too focused on trying to survive as an independent steel producer.

Stock price evolution against the S&P500 from 2011 to present 

Source: Google Finance

As you can see in the above chart, for the period presented (three and a half years), none of the companies had a better performance than the S&P 500. This means that it might not be enough to choose the best company among its peers to pick a winner. You really need to pick a company that is able to produce at a reasonable cost, but also able to keep a differentiating edge that allows it to keep healthy margins.

Summing up
Salzgitter is a very efficient steel producer. However, the company's product portfolio is hugely commoditized, which is incompatible with above average returns. Investing in this company has several risks, like aggressive price cuts from Asian producers, imbalance between supply and demand, and weakness in its main clients. I believe the same is true for the rest of the industry, and probably that justifies the fact that so many companies are unable to beat the S&P 500 during our three and a half year window.

Counterbalancing this gloomy picture, there aren't many upside drivers. The company and the overall industry are depressed and any improvement should be a catalyst for a major stock price appreciation but, honestly, I do not see that coming so soon. On the other hand, there are some opportunities in companies in less commoditized industries, which will probably be better choices than investing in a beaten-down industry lacking significant disruptive innovation since the 80's (Nucor's electric arc furnace).