The 10 Highest Potential Returns in Steel and Aluminum

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In a private speech to the Financial Planning Association, legendary Vanguard founder and former CEO John Bogle made an absolutely critical observation about where the best stock returns come from -- and how to find the next great stock to buy.

He told the assembled guests that only three things drive investor returns:

  • Dividends.
  • Earnings growth.
  • Changes in valuation.

Historically, stocks have returned 9.6% per year on average -- 5%, 4.5%, and 0.1% from dividends, earnings growth, and valuation changes, respectively. Naturally, the best stocks produce the highest combined return.

So which steel and aluminum stocks will earn investors the best returns today? Obviously, no one knows for sure. You should always take future estimates with a grain of salt, particularly when analyst forecasts are involved. In fact, studies show that analysts' long-term earnings-per-share estimates tend to be overly optimistic by roughly 40%, so I've reduced their estimates accordingly.

But investing is all about making predictions based on imperfect knowledge of the future. So long as we're aware of the need to think critically about a company's prospects and to build a margin of safety into our stock purchases, analyst estimates can be a helpful tool for generating ideas. By running the numbers, we can round up the stocks that represent their implied best buys today. Here are our assumptions.

Company

Dividend Yield (Current)

5-Year Growth Rate Estimate (Reduced by 40%)

Implied Price-to-Earnings Ratio (in 2016)

Gerdau (NYS: GGB) 2.6%15%24
China Gerui (NAS: CHOP) 0.0%7%15
ArcelorMittal (NYS: MT) 4.2%16%24
Cliffs Natural Resources (NYS: CLF) 1.5%7%16
Century Aluminum (NAS: CENX) 0.0%12%21
Reliance Steel & Aluminum (NYS: RS) 1.2%10%19
Sims Metal Management (NYS: SMS) 3.3%12%21
Ternium (NYS: TX) 3.2%5%14
Allegheny Technologies   (NYS: ATI) 1.6%19%28
Steel Dynamics (NAS: STLD) 3.5%7%16

Data from Capital IQ, a division of Standard & Poor's. Includes stocks on major U.S. exchanges capitalized at more than $200 million, with positive earnings and at least one analyst issuing long-term earnings estimates.

And here are their implied five-year annualized returns for shareholders. I've ordered the three return components by their reliability -- first dividends, then earnings growth, then valuation.

Company

Dividend Return*

Earnings Growth Return

Valuation Return

Implied Cumulative Annual Return

Gerdau3%15%15%33%
China Gerui0%7%28%35%
ArcelorMittal5%16%24%44%
Cliffs Natural Resources2%7%18%27%
Century Aluminum0%12%13%25%
Reliance Steel & Aluminum1%10%13%24%
Sims Metal Management4%12%6%23%
Ternium3%5%13%22%
Allegheny Technologies2%19%(3%)18%
Steel Dynamics4%7%7%18%

Source: Author's calculations.
*Assumes dividend growth at rate of earnings growth.

The raw numbers tell us that these are the 10 most promising names in steel and aluminum. Of course, analysts' growth assumptions for any individual company could prove overly optimistic or pessimistic, as could their future valuations, so the implied cumulative returns are hypothetical. In particular, some of the implied five-year valuations look a tad aggressive to me. That said, this list helps you focus on this sector's highest potential returners -- and provides an excellent starting point of names for further research.

Don't stop here. If any of these stocks interest you, add them to your personalized stock watchlist to find out more about it. If you haven't started a watchlist yet, you can get started now for free.

At the time this article was published Ilan Moscovitzdoesn't own shares of any company mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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