Real Steel

 | Jan 08, 2013 | 12:30 PM EST
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One thing I have learned in my decades of investing is that very few sure bets present themselves in any given year -- except going with the current SEC champion against any Midwestern team for college football's BCS title at a neutral field. That said, every dog eventually has its day. Stocks and sectors that have underperformed for months or years can be the strongest performers in the months and years ahead. Good examples of this are banks and homebuilders. Both sectors were lousy investments for years but turned around in 2012 to be among the best market performers over the past 12 months.

The steel sector and the companies that supply the industry have underperformed the overall market significantly since late spring. Concerns about a slowdown of worldwide growth, poor pricing, overcapacity and a rough patch in the Chinese economy all contributed to a decline in the sector. Skies seem to be brightening, however, with rising prices and more certainty around demand from China. The sector has started to bounce back. Here are two cheap stocks that could perform well if the sector continues to rebound.

AK Steel (AKS) produces flat-rolled carbon, stainless and electrical steels and tubular products in the U.S. and internationally. Four reasons AKS is a good speculative play at under $5 a share:

  • This is one of the more leveraged plays within the industry. The stock was trading north of $16 a share less than a year and a half ago. It should benefit more than most other plays if steel pricing continues to improve. The company recently increased its spot market base price of carbon flat-rolled steel products by $30 per ton.
  • The company is tracking to an approximate $0.60 per share loss in 2012, but analysts currently having the firm bouncing back in 2013 to post a profit.
  • Insiders have not sold any shares in more than a year, and several stepped up to make new purchases in late November.
  • Goldman Sachs, Longbow, Credit Suisse and Dahlman Rose have all upgraded their ratings on the shares of AK Steel over the past four months. The company has also beat earnings estimates each of the last two quarters.

Cliffs Natural Resources (CLF) produces iron ore pellets, fines and lump ore, as well as metallurgical coal. Four reasons CLF has long term value at $38 a share:

  • The stock is priced at just 85% of book value and less than 6x trailing earnings.
  • Cliff Natural Resources currently pays a dividend of more than 6%. Insiders have also been net buyers of the stock over the past year and at much higher prices.
  • The stock is selling near the bottom of its five-year valuation ranged based on price/earnings, price/book, price/sales and price/cash flow ratios.
  • Consensus earnings estimates have not reflected the significant increase in iron ore prices in recent months. This should be a catalyst in the weeks ahead.

Due the volatility of the sector, its vulnerability to a slowdown in worldwide economic growth and high debt loads, I play this kind of cyclical sector by buying long-term options. If the sector does not rebound as expected, I control my losses. If the sector continues to improve, the options can generate a significant payday. Other cyclical plays, like airlines, would also be good candidates for this risk/reward strategy.

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