This Just In: Upgrades and Downgrades

For steel investors, 2015 has not been a good year.

Over the past 11.5 months (and counting -- steel's down another 1.7% in Monday trading), shares of the Market Vectors Steel ETF have lost 44% of their value. Individual steel companies have done both better than that ... and worse:

• Steel Dynamics (STLD -0.85%) is down "only" 15%.
• Nucor (NUE -0.98%) fell 19%.
• On the other hand, AK Steel (AKS) collapsed 65%.
• And U.S. Steel (X -1.27%) fell off a proverbial cliff -- down an incredible 72%.

Up on Wall Street, though, one smart analyst has been watching the sector like a hawk, and thinks it may be time to swoop in and snatch up some bargains. But they aren't the bargains you'd expect.

Best of the worst
Bright and early Monday morning, international megabanker Nomura Securities announced it is upgrading two of the biggest names in American steel to buy. The analyst didn't, however, pick either of the two stocks that have fallen the lowest, choosing instead to recommend Steel Dynamics and Nucor. Why?

Steel Dynamics
According to Nomura, Steel Dynamics (buy rated, with a $21 price target) is its "top pick" in the steel industry. StreetInsider.com quotes Nomura saying that "STLD has the balance sheet and cash flow to capitalize on the current market dislocation, and we expect management to continue to pursue bolt-on or organic opportunities that improve its product offering and share of the U.S. VAP market."

On the top line, Nomura predicts that we will see "both destocking and import pressure start to fade" in the first half of 2016, allowing revenue to rise. And farther down the income statement, the analyst believes that "sustained pressure on raw materials costs via seaborne scrap values" will allow Steel Dynamics to expand profit margins on these new revenues.

Nucor
Nomura says its buy thesis for Nucor is "similar." The same global trends benefiting Steel Dynamics will work to benefit larger steelmaker Nucor. Additionally, "NUE has a slightly stronger balance sheet than STLD and thus more potential for strategic growth through the current downturn." (On the downside, Nomura sees Nucor as having a bit more "exposure" to the steel plate markets than it would like).

Altogether, the analyst thinks Nucor shares, currently at $40, could rise as high as $47 in a year -- a 17.5% gain. But is Nomura right?

Let's go to the tape
Ranked in the top 2% of investors we track on Motley Fool CAPS, Nomura bears the additional distinction of being rated one of "Wall Street's Best" stock pickers. Over the three years we've been monitoring its performance, fully 65% of Nomura's stock recommendations have successfully outperformed the S&P 500 -- and by a whopping 25 points per pick!

That said, Nomura has struggled to time the steel market's rebound. Here, see for yourself:

As you can see, while generally a strong stock picker, Nomura has been floundering somewhat when it comes to calling the bottom on this particular cyclical commodities market. So what are the chances that Nomura is right about Steel Dynamics and Nucor this time? For that matter, is the analyst right to leave AK Steel and U.S. Steel on the shelf? Don't they deserve upgrades as well?

Here's how the valuations of these four major steel players compare:

All data courtesy of S&P Capital IQ.

The upshot for investors
When looking for a bargain in the stock market, investors sometimes focus too intently on GAAP profits, and overlook a company's true cash profitability -- its free cash flow. Nomura does not seem to be making that mistake, however. Undeterred by poor GAAP profitability in this sector, the analyst has correctly identified the two steel stocks doing the best job of generating cash, and selling for low valuations (enterprise value) relative to the cash they produce.

Taking debt into account, and valued on its free cash flow and growth rate, Steel Dynamics does indeed appear to be the best bargain in steel today -- and Nomura is right to recommend it. I'm a bit less sanguine about Nucor's prospects, but only a bit. Its strong record of cash generation, moderate debt load, and above-average growth rate all argue strongly in that stock's favor as well. In contrast, neither AK Steel nor U.S. Steel look attractively priced at current levels.

Long story short, I find myself in agreement with Nomura today. They've made the right call, and Steel Dynamics does indeed deserve the title of a "top pick" in steel.