When big macro news comes down the pike that promises to change the fundamentals in a sector, frequently the stocks that rally hardest are those that belong to the most “endangered” companies.
Which doesn’t mean those are the shares that you want to buy after the first big enthusiasm starts to be colored by a bit of reality.
We saw that in the rally in the energy sector after OPEC announced an agreement to cut oil production when shares of ocean drilling companies with their high leverage to oil prices and shaky balance sheets soared while more fundamentally sound land drilling stocks lagged. Ocean driller Transocean (RIG) is up 43.68% in the last month whereas shares of diversified oil services technology leader Schlumberger (SLB) is up just 5.87.
And we’ve seen it in materials stocks after Donald Trump’s victory in the presidential election. Trump’s campaign promise to put $1 trillion to work rebuilding U.S. infrastructure lit a blast furnace under steel stocks with United States Steel (X) climbing 70.67% in a month. One reason for the stock to soar is that U.S. steel is a relatively high-cost producer still reliant on older blast furnace technology. Trump’s infrastructure promise plus his rhetoric about ending unfair trade with countries such as China would make a big difference in steel prices for U.S. Steel–no minor event since the company’s operating margins look like they were negative (again) in 2016. A lower cost producer such as Nucor, which uses newer arc furnace technology to make steel from scrap instead of iron ore, rose too on Trump’s victory but by a relatively more modest 26.83% in the last month.
This observation about how the shares of fundamentally shakier companies rally hardest on news like this from the President-elect extends to industries within a sector. Steel has attracted relatively more interest from investors, and shown more impressive price gains, because it has such as tough task ahead of it in the global marketplace. China is the biggest and dominant global steel producer and the country has been willing to do just about anything it can to support its domestic steel industry during a downturn in domestic and global steel demand. If that has meant dumping steel below cost on global markets, so be it. (And it’s not like China has been the only country guilty of this practice. Other guilty parties include Russia South Korea, Brazil, and Turkey.) The Obama administration brought anti-dumping and counter-subsidy actions against China’s steel industry in 2015 and 2016. But steel imports have continued to gain market share in the United States with imports accounting for 29.1% of the market in 2015, up from 20.9% in 2010.
The U.S. steel industry isn’t just fighting its own historical under-investment in new technologies (by what I’d call legacy steel makers such as United States Steel) and the huge export-oriented Chinese steel industry, it also has to work against a rising U.S. dollar. With the U.S. economy growing faster than any other major developed world economy and with the Federal Reserve set to raise interest rates in a little more than a week, I think it’s a good bet that the U.S. dollar will continue to climb. And that will make U.S. steel exports more expensive (and China, Brazilian, etc. steel exports cheaper) on global markets. In this situation I think stocks of U.S. steel makers have gotten ahead of themselves and run up on enthusiasm over an infrastructure promise that will face a disillusioning slog through the mire of Congress. (Already it’s clear that Democrats will oppose the package because it is built on government guarantees and tax credits to private investors in infrastructure, which Democrats say will limit the number and kind of new projects that get built. Conservative Republicans haven’t given up their opposition to any government spending just because Trump is set to move into the White House.)
Which is why I prefer aggregates to steel and why I’ll be adding shares of Vulcan Materials (VMC) to my Jubak Picks portfolio tomorrow.
In contrast to the steel sector shares of aggregate producers–the companies that provide the rock and gravel (and in some cases concrete) that form the key ingredients in road and building construction–moved higher on enthusiasm for the Trump infrastructure plan but by no means as strongly as the steel makers and in many cases have pulled back recently off their highs as more details emerged about how tough it will likely be to find a way to fund this infrastructure package. Shares of Vulcan Materials, the largest U.S. aggregate producer, are up 7.69% in the last month, having climbed all the way to $136.04 on November 10 before closing at $127.50 today, December 5. The No. 2 company in the sector, Martin Marietta Materials (MLM) is up 12.7% in the last month.
One of the reasons that I like shares of an aggregate producer such as Vulcan Materials is that the fundamental story isn’t dependent on what they may or may not do in Washington in the next six months or so. Thanks to the passage of the Federal Highway Act in December 2015, Vulcan has already seen rising demand for its aggregates. Standard & Poor’s forecasts a 13% increase in sales in each of 2017 and 2018–even without the Trump infrastructure goodies. Vulcan has used the down cycle for demand to its advantage too by working to lower costs per ton. Gross margins for its aggregates climbed to 91% in the third quarter of 2016 from 80% in the trailing 12 months and against 77% for the full 2015 year. With a recovery in volume, those margins will produce very solid earnings growth of, S&P projects, 44% in 2016 to $3.10 a share and 55% growth in 2017 to $4.80. That earnings growth would take the stock’s current price to earnings ratio of 46.55 on a trailing 12 month basis to 41.12 on projected 2016 earnings per share and to 26.56 on projected 2017 earnings per share. The projected PEG ratio (PE to growth rate) of 0.8 is a discount to the stock’s two-year PEG average of 1.2, according to S&P.
Any extra aggregate demand–and price increases–from a new infrastructure initiative from the incoming Trump administration would be icing on top of this cake.
I’ll be adding this stock to my Jubak Picks portfolio tomorrow with a target price of $160 a share. Vulcan Materials pays a small 0.8% dividend. (And in case you can’t remember, my first Trump pick was Acadia Pharmaceuticals (ACAD).)