(Photo: Bernd Vogel/Corbis)

The S&P 500 has been on a tear lately, climbing more than 20% since October. While that’s been good news for most people’s portfolios, it’s made hunting for undervalued companies a challenge. The index’s price-to-earnings ratio has jumped from about 12 times earnings back then to around 14.5 times today. One industry, however, continues to be undervalued: steel.

After three stellar years between 2006 and 2008, the steel sector fell off a cliff in 2009. The two largest consumers of steel, the construction and automobile industries, nearly came to a standstill; the construction market was operating at about 70% below where it was before the financial crisis, and two of America’s largest vehicle manufacturers went bankrupt. Thanks to this slowdown, many steel companies saw share prices fall and valuations drop. The sector is slowly improving—auto companies are again buying the commodity—but steel companies are still historically cheap. “It’s an interesting time in the industry,” says Patrick Kaser, a portfolio manager at Philadelphia-based Brandywine Global Investment Management. “It’s very much in the investors’ favour.”

The steel industry is one of the stock markets’ most cyclical sectors. When the economy does well, so do steel companies. When it falters, these businesses suffer. That’s a big reason why it hasn’t rebounded as quickly as other sectors; people are still worried about the global economy. However, numerous indicators are pointing to a sustained recovery. The U.S. building sector, a big consumer of steel, added 55,000 jobs between March 2011 and March 2012, while construction workers’ unemployment has fallen from 24% in 2010 to 17.5%. The sector will have its ups and downs in the short term, but, says Kaser, in the longer run it will come back to life.

Bridget Freas, a senior analyst with Chicago-based Morningstar, says that U.S. demand for the commodity is increasing, which is helping boost steel prices. Last month, steel cost about US$600 a tonne; today it’s around $700. While the price could appreciate further, that’s not what will make these companies more profitable, she says. It’s when input costs fall—which she thinks they will—that we’ll start seeing profits soar.

Steel is created from three raw materials: iron ore, metallurgical coal and scrap metal. Those first two commodities have dramatically risen in price in recent years. Over the past five years iron ore has gone from US$36.63 per metric tonne to $187 last February. It’s now at $145. Metallurgical coal has climbed from around $90 a tonne in 2007 to around $200 today. The rise in input costs has killed steel margins, but Freas thinks those prices could fall. China consumes about 700 million tonnes of steel a year—half of all the steel made around the world—but it manufactures most of that domestically. Still, the country is a huge importer of iron ore and coking coal, and over the past five years Chinese demand has driven these prices up. But as China throttles back the massive infrastructure investments that have kept its economy roaring the past few years, its need for both steel and the materials that make it will fall. Then, Freas says, input costs will drop, making it cheaper for everyone to produce steel.

There is some concern that China will continue to run its plants near full capacity. If that happens, it could start exporting steel to the U.S. and Europe, which may then cause steel prices to fall. The fear of a hard landing coupled with oversupply is a big reason why steel companies’ valuations are still so low. Kaser, though, doesn’t think the Chinese economy will crash. He thinks demand for cars, appliances, office space and other things made of steel will stay strong.

There’s also some doubt whether China even wants to export steel. “It’s a bad business for them,” says Rob MacDonald, an associate portfolio manager with Thornburg Investment Management based in Santa Fe, N.M. Chinese steelmakers are already losing money on production, and there’s pressure to reduce carbon emissions.

When, sooner or later, the steel industry does come back, it’ll be better positioned to weather a downturn, says Kaser. A decade ago, producers would often run mills at near full capacity regardless of demand. Now, though, he says they’re far more willing to shut down mills that are not economically viable. “The fact that companies are rationally looking for returns is positive, longer term,” he says. One sign of this trend is that companies are only slowly ramping up production. Before the recession, capacity utilization—the percentage of mills operating—was around 90%, about as high as it can get. In 2009, capacity fell to about 40%; today it’s around 80%. That’s not only a signal that the sector is coming back, says Freas. It also shows that these companies aren’t willing to run mills ragged like they used to.

Because the sector is so cyclical and so sensitive to the broader economy, picking the right stocks can be tricky. Ari Levy, manager of the TD Resource Fund, says that price-to-earnings isn’t the best ratio to use. It’s difficult to predict where earnings will be in the coming years. And trailing earnings, tracking the previous 12 months, are useless. He prefers looking at the enterprise multiple, which is enterprise value (EV) divided by earnings before interest taxes and amortization (EBITA). That normalizes the differences between the different companies, he says, which is important because a lot of these companies have different capital structures. A lower enterprise multiple means a better buy. Several steelmakers have a ratio of five or six, which is cheap, says Levy.

Investors also need to look at debt levels. Freas says that many operations went on acquisition sprees and made heavy capital expenditures during the good times. When the market tanked in 2009, many had to restructure their debt. Some companies still have a debt-to-EBITA ratio between four and five times, which is too high for a cyclical business. Look for a company with a debt-to-EBITA ratio below two, she says.

Kaser also takes free cash-flow yield into account. This metric, he says, shows whether or not a company is burning through its cash. He likes to see a free-cash-flow-yield-to-equity ratio of around 10%, but the steel companies aren’t there yet. Some even have a negative free-cash flow yield, which isn’t ideal, but as long as it’s not below –5% it’s not a deal breaker. Many companies also pay dividends of 3% to 4%. That’s a bonus—“you get paid to wait,” says Kaser—but don’t buy steel stocks purely for income. In tough times, they tend to cut their payouts.

While there are currently some great deals on the market, investors may have to wait a while before seeing returns. But those returns will come, says Freas. “It’s a sector that takes two steps forward and then one step back. But over the long haul, this sector is pretty important to economic growth around the world.”

The CB Hotlist

ArcelorMittal SA
(NYSE: MT) P/E: 15.47 | Mkt cap: $28 bil
1-year return: -48.4%
Based in Luxembourg and heavily exposed to Europe, this company suffered a double whammy last year. But it owns iron ore mines, which can help it weather the sector’s volatility, and it pays a 4.2% dividend.

Nucor Corp.
(NYSE: NUE) P/E: 17.44 | Mkt cap: $13.5 bil
1-year return: -7.8%
Morningstar analyst Bridget Freas likes Nucor, based in Charlotte, N.C., because of its clean balance sheet. Its debt-to-EBITA ratio is 1.5 times, which is much lower than many other companies that levered up before the recession.

Posco
(NYSE: PKX) P/E: 9.23 | Mkt cap: $29.6 bil
1-year return: -24.1%
Although China makes the majority of its own steel, it does import some of it. This South Korean firm is one of the few that sells into the country—about 30% of its production is exported to China. Fears of a hard landing there have weighed down its shares.

Tokyo Steel Manufacturing Co.
(TYO: 5423) P/E: n/a | Mkt cap: $1.3 bil
1-year return: -20.4%
This Japanese company will be busy in the coming years, says portfolio manager Rob MacDonald. It should play a big part in the country’s post-tsunami reconstruction. It will do that with the help of a recently completed, state-of-the-art facility that has added about 60% to Tokyo Steel’s existing capacity.

(All $ figures in US$)