4 Steel Stocks to Strengthen a Portfolio

This classic "old economy" sector is booming, thanks to global demand.

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Think American factories are suffering? Not in steel.

The ultimate "old economy" sector is having one of its best years in recent memory despite (and even partly because of) the slowing U.S. economy.

Steel prices are soaring because of rising global demand, the weak dollar, and some long-term consolidation in the industry that let top producers raise prices on big customers even as demand in the United States faltered.

This year, prices for benchmark hot-rolled steel have climbed to $1,187 a ton, according to TheSteelIndex.com. While prices may pull back during the normally slow summer months, analysts predict that higher prices for the metal—just like those of oil and most other raw materials—are here to stay. Goldman Sachs recently upped its steel price forecasts to $936 a ton this year, $1,000 for 2009, and $936 for 2010. Compare that to fourth-quarter prices that averaged just over $530.

At the same time, production costs have climbed more than $300 per ton over the past year, but it hasn't been enough to slow steelmakers' impressive profit growth.

"Steel prices are still going up. Costs are going up, but they're going up less. As a consequence, profit margins are going up dramatically," says Charles Bradford, an analyst at Soleil Securities. "Spreads have widened, and that's the game."

It has all been a boon for investors at a time when few other sectors outside commodities and energy are offering much in the way of returns.

Steel stocks tracked by the Market Vectors Steel Index ETF are up more than 58 percent over the past year, and more than 27 percent for 2008 alone.

America's economic troubles have actually contributed to steel's success. Earnings power in the sector has accelerated because of a weak dollar that is driving demand for American steel abroad. At the same time, cheaper imports that flood the United States when the dollar is strong are being kept at bay by the weak greenback, higher demand in emerging markets, and soaring shipping costs.

That confluence of factors has offset declining sales to the ailing U.S. auto and construction sectors.

"Consumption of steel in the U.S. is terrible. Having said that, imports are down dramatically and exports are up, so demand for steel is not bad even though [U.S.] usage is terrible. That's never happened before," Bradford says.

That has led to a tentative renaissance for American mills. Formerly hamstrung by the wide gap in wages between American and foreign steelworkers, production in the United States is on the rise for the first time in years.

And a decade of major consolidation in the industry has left steelmakers with a good bit of power to keep raising prices for their customers even as consumers and corporations are spending less.

Huge swaths of the American steel industry went bankrupt early in the decade when prices were depressed and a "strong dollar" recession crimped profits. Some 30 American mills shut down between 2001 and 2003.

Now, just three firms—Nucor, U.S. Steel, and ArcelorMittal—control about two thirds of global output. That elite core of huge global players has streamlined operations by buying up steelmaking rivals and producers of iron ore, coke, and other key materials used to make steel. The result has been more efficient operations and more clout to dictate prices to customers.

"What the market is being exposed to in '08 is the value of the vertical integration process and having the availability of raw materials," says Mark Parr, an analyst with KeyBanc Capital Markets.

So steel seems to be sloughing off the slow economy, as demand appears to be healthy as long as imports remain lower and the dollar stays weak.

Valuations might be a bigger concern. Steel stocks have already had a great run during 2008.

Soleil's Bradford says most of the sector is ahead of itself. He says shares are trading as if there were still a consolidation boom happening, with speculation pushing up share prices even among the largest names like Nucor and U.S. Steel.

CIBC World Markets says there's room for higher earnings this year, but it warns against buying steel stocks trading at a price above 10 times their projected 2008 earnings. Prices could also pull back more than expected if already dismal automotive demand continues and sales of gas-thirsty and steel-heavy SUVs brake hard.