Peter Lynch Would Snap up This Stock

To make money in stocks, it often helps to study history’s greatest investors. Like many finance enthusiasts, I’m a fan of Peter Lynch, who’s best known for his spectacular results as manager of the Fidelity Magellan Fund from 1977 through 1990, when the fund’s total returns averaged +29% a year.

A Lynch principle you can apply right now to beat the market is his approach to troubled industries. “If you’re thinking of investing in a troubled industry, buy the companies with staying power,” Lynch has instructed investors. “Also, wait for the industry to show signs of revival. Buggy whips and radio tubes were troubled industries that never came back.”

When I hear those words, I think of the steel industry today. This industry certainly qualifies as troubled. It tanked badly during the 2009 recession, booking combined net losses of more than -$370 million and posting an operating margin of just 2.2%, a seventh of 2008’s operating margin. The industry also saw capacity utilization drop below 50% during the recession, its largest productivity decline in decades.

Yet the signs of revival Lynch would have us look for are there. Sales, though still well below 2006 through 2008’s levels, have improved and should finish the year fully +30% ahead of last year’s. For 2010, analysts are forecasting the industry to post combined net profits of $430 million, a +215% jump from 2009, and an industry-wide operating margin of 5.5%, more than double last year’s.

So we’ve clearly got a troubled industry in recovery, and I think it’s safe for us to say its product won’t be going the way of the buggy whip or radio tube any time soon. So what next?

If we want to invest like Peter Lynch, we need to find steel companies with staying power. The best prospect has been around for more than a century and is the largest steel manufacturer (by production) in the United States. Before the 2009 recession, it was profitable in every quarter since 1966.

When the recession hit, however, sales fell more than -50% and the company lost -$0.94 per share, which looked especially horrible next to 2008’s $6.01 a share in earnings. But even then it showed staying power, maintaining a strong balance sheet, high free cash flow and a 3% dividend yield.

In my opinion, no domestic steel play has better prospects for the future than Nucor (NYSE: NUE). Sales are expected to rise by nearly +40% this year and then by an average of +16% annually for the next four years. Five-year earnings forecasts call for growth averaging +15% to +16% annually, compared with +11% for the industry. Based on these estimates and a projected yield of 2.6%, total returns of +20% to +30% a year and an absolute return of +85% to +180% are feasible for this stock in the next four years.

A highly decentralized management structure is one of Nucor’s main strengths. Such a structure has fostered innovation, nimble decision-making and daily attention to cost-efficiency on the front lines. It certainly helped the company weather the recession in much better shape than most of its rivals. Also notable is the fact that most Nucor employees are non-union, so there is less likelihood of labor disputes disrupting business or raising costs.

Nucor’s sales are concentrated in the United States, but that’s a good thing right now. Domestic steel prices fell a lot during the recession and are now much more aligned with foreign steel prices. So U.S.-based customers, whose inventories are at historic lows, have been looking to domestic suppliers like Nucor since they can fill orders much more quickly than foreign sources, but at a comparable price.

Still, management knows the trend won’t necessarily last and is venturing into overseas markets to exploit growing steel demand in developing countries. The goal for 2010 is to increase exports to 15% of sales from 11% a year ago.

Also, last March, the company announced a joint venture with Tokyo-based Mitsui USA, a diversified investment and service firm that, among other things, supplies iron and steel products, along with chemicals and plastics. The joint venture is expected to greatly facilitate Nucor’s expansion domestically and abroad.

Action to Take –> Nucor currently trades at about 17 times forecasted earnings, so don’t be alarmed by its excessively high trailing price-to-earnings (P/E) ratio of 62. It’s simply the result of a common quirk in cyclical industries like steel — the tendency for P/E ratios to move opposite the economic cycle. [See my colleague David Sterman’s brief but excellent description of this phenomenon]

Also, I wouldn’t necessarily expect Nucor to deliver large gains in the near term. At current prices, it may not be all that timely. Rather, buy the stock for the same reasons Peter Lynch would: staying power and the ability to generate top-notch long-term returns.

P.S. — Any analyst can tell you they like a stock. But how many are willing to put their money where their mouth is? StreetAuthority Market Advisor is so confident in Nathan Slaughter’s picks that we gave him $100,000 in cash to put into his recommendations. Learn how you can join in and profit along with him.