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Steel Stocks Are Due for a Fall. What to Know.

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Steel prices have gained nearly 60% in 2021.

Courtesy of U.S. Steel Corporation

When steel prices soar, the return to earth is usually swift and painful—and that goes for steel stocks too.

Steel prices have gained nearly 60% in 2021, as commodities have rallied around the globe. It’s helped that steel companies had cut back on production during the pandemic, making the metal just one more commodity that has experienced high demand at a time of low supply. That’s been great for

U.S. Steel

(ticker: X),

Steel Dynamics

(STLD),

Nucor

(NUE), and others: A basket of six U.S.-traded steel companies has gained an average of 43% in 2021, nearly four times the

S&P 500’s

11% rise.

Steel prices can’t go up forever, and history suggests they are nearing a peak. Since the start of the millennium, there have been four previous steel surges—in 2004, 2008, 2016, and 2018—in which prices rose between 37% and 84%, according to BofA Securities analyst Timna Tanners. Those surges were quickly followed by tumbles of between 37% and 65%. Tanners isn’t the only one thinking along these lines. When Goldman Sachs analyst Emily Chieng initiated coverage of the sector on April 9, she also noted that steel is in the “latter stages of the upcycle.”

Unfortunately for steel companies, the stocks tend to follow steel prices. Of particular importance are profit margins, particularly Ebitda margins—for earnings before interest, taxes, depreciation, and amortization—Chieng explains. Stocks tend to follow margins, which bottom at the beginning of a cycle and then flatten out at the end of it. “Given this, we would recommend investors exercise caution at this point of the cycle, as we now expect more modest risk/reward from here,” she writes.

That doesn’t mean dumping steel stocks en masse. This cycle could be longer than normal, while margins could stabilize at higher levels than in the past. If that’s the case, investors should steer themselves away from companies with more debt and a need to invest—such as U.S. Steel, rated Underperform by Tanners and Neutral by Chieng—and favor those that have strong balance sheets.

Steel Dynamics, which has Buy ratings from both Tanners and Chieng, might fit the bill. The company’s balance-sheet strength—its net-debt-to-equity ratio was just 1.5 times at the end of 2020 and could fall to 0.6 times by the end of 2021, the Goldman analyst says—should allow it to invest for growth and return cash to investors. And with a new plant opening in Sinton, Texas, late in the year, Steel Dynamics will have more exposure to the higher-margin auto business.

That won’t protect an investor if steel prices do tumble, but it would certainly limit the damage.

Write to Ben Levisohn at [email protected]

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