Steel Industry

After 186 posts about value investment philosophy, I think it’s about time to write about something else. Well, after all, value philosophy can actually be surmised into just 3 words. So, I am actually quite amazed why I could write so much. So going forward, hopefully I can write about industries and individual stocks. As and when new ideas hit, I will still talk about value philosophy and the big picture. Ultimately, that is what’s most important and what will drive long term return for investors.

In this post, I would like to talk about the steel industry. Steel is a basic commodity used by humans and has been pretty integral throughout the development of our civilization. Sadly as a business, it sucks. The industry as a whole doesn’t really create much value for shareholders although there are periods where it churns out enough cash to whet some appetite.

Today, about 1 billion ton of steel is consumed every year. China accounts for half of the usage. Outside of China, Asia including Japan, accounts for bulk of the rest. Well, this is unsurprising as steel is mostly used in construction and infrastructure which Asia needs, a lot.

The business model is simple enough. Buy raw materials like iron ore and coking coal, throw it into a blast furnace, out comes molten steel, add some other metal to make it better (like nickel for stainless, or zinc coat it for shine) and process it into sheets or beams etc. This in itself is not bad. What is bad is:

1. Both the input and output prices are uncontrollable.
2. Competition is very, very tough
3. It is very capital intensive

Raw material prices are controlled by the ore majors: BHP, Rio Tinto and Vale. Specifically, they dominate the spot market and use the spot prices to determine contract pricing. So the steel makers have no say in pricing. The final product prices are also determined by the spot market. There are international market prices for a variety of steel products including the most famous hot rolled coil (or HRC), for H-beams used in construction, for pipes etc.

The reason why such spot markets developed is probably bcos there are simply so many players in the market that is just have to be done for the benefit of both the steelmakers and their buyers. With such markets, products could be standardized, distributors can handle them easily and lengthy negotiations could be avoided. But that’s bad for profits.

But why are there so many steelmakers globally? Well, in the past, it was a country’s ambition to have its own steel mill. It’s a symbol of strength for the nation. The western countries had it. Japan still has it. Korean has it and now China and India are building theirs. What’s worse is when the various provinces or prefectures also decided that they should have, hence you have all these few hundred steelmakers all over the world, each having less than 1% of the global market.

In the middle of this decade, someone decided to restructure the whole industry. His name was Lakshmi Mittal. So he started buying small steel mills all over the world. But he realized that wasn’t enough. There were just too many. In a move that shocked the industry, he decided to buy over one of the biggest steel players globally. Today, his company is called ArcelorMittal and it has capacity of 100mn tonnes or 10% of the market.

But still, 10% is nothing in a world where the suppliers and customers are much stronger and you still have over a few hundred competitors. ArcelorMittal, amazingly, has been able to generate good cashflow by squeezing cost and investment. Unfortunately, the money has to be used to pay down debt and it will take another 5-6 years to bring debt down to a comfortable level. Not to forget, by that time, it probably needs to resume its capex plans as well.

Which brings us to the 3rd point. Steel is insanely capital intensive. It takes USD 1,000 to bring 1 ton of new capacity on. For ArcelorMittal to increase capacity by 10%, it will cost USD 10bn! That’s one sixth of its equity base today. Most other steelmakers are not even that half its size and a new blast furnace project almost always means new financing.

So in short, the steel business, though integral to the development of our civilization, is bad business. There is usually nothing left for shareholders, after everything is said and done.

Well, that is the big picture. Value investors are also stock pickers and hence the dynamics can change for individual companies.

Buffett had a stake in the Korean steelmaker POSCO for the longest time. The story for POSCO is that the company is the No.1 leader in a country that is perpetually in short of steel despite being one of the biggest exporters of steel intensive products like ships, cars, and consumer electronics. What is more amazing is that POSCO is also one of the world’s lowest cost producers of steel. It can achieve this bcos it has the most integrated high capacity steel mill in the world and it also attracts the best talent in Korea to work for the firm. To that end, it even has its own university!

Hence the firm consistently generated free cashflow and paid dividends while having a clean balance sheet with no debt. Having said that, the wheels of fortune might be turning as Hyundai tries to break its monopoly in the Korean steel market while the company had also tried unsuccessfully to expand into the Indian market. In recent times, the dividend has fallen to 2% while free cashflow yield is also below 5%.

So that’s a short summary of one of the oldest industry on earth. In short, it’s best to avoid, as the industry had not been very profitable for shareholders except for the 5 years starting 2003 when the whole world got into a once in 30 year situation whereby there was a shortage of steel. This happens when a big country industrializes after a long drought and no new investment was made in steelmaking. The last country before China was Japan, which started the steel boom in 1970s.

Next on the list is India, but that might be 2030, if we use the once in 30 year rule.

A Girl in the Convertible

There were some academic studies done on capital structure some years ago by two professors. I only remember the study as the M&M theory. M&M being the initials of the two professors. Both professors subsequently won Nobel Prizes! The same theory also talks about dividends, and I thought that the conclusions are worth sharing here.

According to the study, in a perfect world where there are no taxes, no legal or accounting fees and stocks are infinitely divisible, then it doesn’t matter whether stocks pay dividends or not. Bcos investors can just sell part of their holdings whenever they feel like paying themselves some money.

In the bigger scheme of things, it also doesn’t matter what the capital structure of the company looks like. The firm’s capital can be 100% debt or 100% equity or any other makeup, it doesn’t really matter. What matters is that the firm will only be able to generate enough profits to keep it from going bankrupt, and the market price of the firm is always the right price, ie its intrinsic value. And this is the basis of the Efficient Market Hypothesis.

Luckily the world is not like that and dividend matters. A bird in hand is worth two in the bush. Or as Warren Buffett puts it, a girl in the convertible is worth five in the phonebook. So as investors, we want some dividends to come to us, regardless of what Nobel Prize winners theorize.

Hence, I personally like to find good dividend stocks, and hopefully the firm also enjoys a bit of growth over time. The Dividend Aristocrats of the S&P500 is really a good hunting ground for high quality global names. As for Singapore, I have generated some dividend stock lists in the past couple of years. The most popular one is at the right column of the blog.

Some would question why this huge emphasis on dividends? If a high quality firm can compound its growth much faster, it would be wise to let the firm keep the money and use it to grow. This is the excuse most growth co.s don’t give dividends. Even after they become ex-growth, and they happily squander the cash in stupid ventures or M&As.

Perhaps the best positive example is actually Berkshire Hathaway. Since Buffett can compound growth much better than most people, it doesn’t make sense to pay dividends to his other shareholders. However it is difficult to find managers who can efficiently use capital to compound growth better in the first place. So returning excess cash to shareholders or doing share buyback when the stock is cheap is what a good CEO would do.

Paying an ok dividend also signals that the management have shareholders in mind. (This is also called the signalling theory). Ok being like 2-3% dividend yield, which is whatmost of the Dividend Aristocrat stocks are paying currently. The thinking on this would be something like: Well we don’t need ALL the money to grow, bcos we are in such a fabulous business, we can still grow with limited capex and can generate good cashflow too. And so we would pay our shareholders some dividends, while we continue to grow. Just as we did in the last 25 years.

The long and short of this all is that a stock has a good track record of growing its dividend payment is probably one of the best deals out there (if you can grab it at a reasonable price). Which is probably why Warren Buffett holds quite a number of Dividend Aristocrats like J&J, P&G and Becton Dickinson.