The S&P 500 Index has roughly doubled since it hit a bear market low on March 23, 2020. The national steelmaker’s share price Cleveland cliffs (NYSE: CLF) has grown by more than 550% since that same point. Before you get excited about this massive outperformance, you need to understand a few things about the company and the industry in which it operates.
Cleveland-Cliffs is one of a handful of notable national steelmakers, but it hasn’t always been so. At one point, just a few years ago, it was actually a simple supplier to the steel industry, selling iron ore to steel producers. But the company decided it needed to shift gears and become an integrated steelmaker, with operations ranging from iron ore mining to steelmaking itself.
The company bought AK Steel in financial difficulty, turning into an integrated steel company. Soon after, he added the US steel assets of the global steel giant Arcelor Mittal, which quickly made it one of the biggest names in domestic steel. In just a few short years, Cleveland-Cliffs has essentially evolved into a new business.
The timing for this movement turned out to be quite good as the steel industry has recovered massively. As noted in the introduction, looking back at the end of the 2020 pandemic bear market, Cleveland-Cliffs stock is up over 550%, easily beating the gains of the S&P 500 Index. it also easily left the rest of the major North American steelmakers, as shown in the graph below. Iconic United States Steel (NYSE: X) is the second best performer in the industry, with a gain of around 300% over the same period.
The stock really put on an impressive display. But there is more to understand here than the performance of the stock.
It’s time to buy ?
To begin with, the steel industry is very cyclical. This basically means that steel stocks tend to rise and fall with the economy. Big changes in capital spending, like those proposed by the recently signed infrastructure package, can be major favorable winds, as such investments usually require massive amounts of steel. Given the economic recovery from the coronavirus-related economic shutdowns and new infrastructure spending looming on the horizon, you can see why investors would love steel stocks.
The problem is, Wall Street tends to be forward looking and often incorporates a lot of good news in times of recovery. When the industry inevitably slows down, investors are often content to run for the hills, resulting in significant underperformance. If you look at the performance of US Steel industry peers, Steel dynamics, and domestic indicator Nucor (NYSE: NUE) during the 2007-2009 recession, you can see exactly how dramatic the ups and downs can be.
With Cleveland-Cliffs and the rest of the steel industry recovering sharply, the risk is really on the downside. All it will take is for the economy to start to slow down and investors are likely to start exiting the stock in large numbers. It’s just the way the industry works.
Part of the problem with Cleveland-Cliffs is that it uses blast furnaces, which are expensive to operate and must operate at high capacity levels to be profitable. They are very profitable when used well, but when demand decreases these mills can quickly become unprofitable. US Steel is also a heavy user of blast furnaces, and its profit margins compared to Nucor, which uses more modern and flexible electric arc furnaces, are telling. The makeup of the Cleveland-Cliffs company is more similar to that of US Steel than that of Nucor.
So when the next industry downturn arrives, which will eventually happen, Cleveland-Cliffs could suddenly shift from being an industry leader to being a laggard. And the change could take place quite quickly.
Exciting on the rise, but …
To be fair, Cleveland-Cliffs as a business will benefit from the increased demand for steel. Not only from its own factories, but also from those of its competitors who are increasing their purchases of iron ore. Cleveland-Cliffs is therefore a kind of leverage in the domestic steel market.
However, before you go out and buy it, make sure you understand that what goes up can go down too. It is not, at least at current prices, an investment of the type to be settled and forgotten. No national steel mill currently exists, but with recent changes in Cleveland-Cliffs operations corresponding to an industry recovery, it’s really important to make sure you get the big picture. Don’t get carried away by the story behind the company’s timely transformation to the point of forgetting the inherently cyclical nature of its business.
This article represents the opinion of the author, who may disagree with the âofficialâ recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.