Do Trump's Tariffs Have You Thinking About Steel Stocks? Read This First

Admit it: The moment you caught word that President Trump mentioned that his administration would enact tariffs on steel, your first thought went to steel stocks. Even if you didn't have an immediate urge to invest in steel, you at least thought that steel stocks would have a great day.

(They did.)

For some, there is a certain temptation to jump into steel stocks and ride the wave of higher domestic prices to higher profits. If you are a buy-and-hold investor, though, then there are a couple of things you should probably consider.

We've done this before, and it hasn't changed the equation yet

Today, the global steel market is dominated by China and the amount of steel it can produce. The country's total exports of 100 million tons in 2015 was more than the second largest steel producer's -- Japan -- total output. For years, China used much of that steel to fuel its incredible growth rates, but it has since backed off the throttle with infrastructure spending. As a result, there has been a flood of excess supply on the market that has left many steelmakers reeling.

Even before China's emergence as the dominant global supplier, the U.S. has sought to enact tariffs to counter oversupply. In 2002, then-President George W. Bush implemented a tariff structure that would impose up to a 30% duty on imported steel for three years. However, those efforts were short-lived as the World Trade Organization deemed them illegal and allowed other countries to take retaliatory measures. Then, in 2016, then-President Obama set duties as high as 235% on Chinese imported steel and some other countries in an attempt to curb dumping.

The one noticeable change between Trump's tariff proposal and the ones enacted by his predecessors is there don't appear to be any exempted countries. Both Bush and Obama exempted countries with which we have free trade agreements and a few others. The consequences of that move, though, aren't totally clear at this point.

From an investors standpoint, there are two things that should stand out. One is that tariffs don't necessarily change the global oversupply issue, and that tariffs have historically been a temporary thing. It seems as though every time this industry goes through booms and busts, producers cry foul. If you are looking to invest in a company over a multiple-year time horizon based on these tariffs being in place, then chances are, you are going to be sadly disappointed.

All the lipstick in the world doesn't change the fact that it's a pig

Let's say for argument's sake that these tariffs get enacted and remain in place for a long time. Even if that were the case, it doesn't change the fact that the steel industry hasn't historically been a great investment. Steel is, at its heart, an incredibly capital-intense business selling a commodity product where demand for that product waxes and wanes with the global economy. That leaves you with companies with little to no pricing power trying to predict which way the wind will blow. Considering how poor people are at making predictions, you can probably guess how that turns out over time.

If you need a reminder, though, let's look back at a chart from Credit Suisse's Global Investment Returns Yearbook from 2015. In it, the analysts tracked the performance of $1 invested in various industries dating back to 1900. If that $1 was invested in steel, it would be worth a little under $10,000 in 2015. That sounds great...until you find out that same $1 in the broader market in 1900 would be $38,255 in 2015. Steel has, and will likely continue to be, an underperforming industry.

If the cumulative returns of steel weren't already less than ideal, the lure of higher prices and a more protected steel industry will almost inevitably lead investors to pursue stocks with "higher upside": Companies selling at extremely low valuations for one reason or another. In reality, though, higher upside is just a euphemism for a poorly run business that may get a temporary boost from something completely out of their control. If a management team is bad at allocating capital, it won't matter where steel prices go because their management teams will likely find a way to muck things up.

Perhaps the quintessential example of this was United States Steel's (NYSE: X) $1.1 billion purchase of Canadian steelmaker Stelco back in 2007. At the time, Stelco was a company that had just recently reemerged from bankruptcy and had 1.7 billion Canadian dollars in underfunded pension obligations and another CA$750 million in debt. Despite these red flags screaming "STAY AWAY," U.S. Steel's management saw steel prices at an all-time high and decided that this "very dynamic industry" was worth paying a 43% premium for a distressed asset.

To the surprise of no one, U.S. Steel Canada -- the name of its Canadian operations post-acquisition -- filed for bankruptcy protection in 2014, and the unit was ultimately sold for $124 million in 2016. It's moves like these that have made U.S. Steel an incredibly poor capital allocator over the past decade and caused it to sustain heavy losses.

U.S. Steel isn't alone, either. AK Steel Holding has also historically struggled to generate sustained returns on capital since the early 2000s because of high debt loads and a reliance on older steelmaking technology that makes it less responsive to changes in supply and demand.

A bump in steel prices might give these companies a bump to their top lines, but it won't prevent management teams from making bad decisions. They'll likely continue to make stupid acquisitions when times are good and desperate divestment decisions when the next crash comes.

What a Fool believes

I don't want to dissuade investors from looking at the steel industry completely. In every industry, no matter how challenging, there are some quality, well-run businesses that deserve our attention. What is more important is that investors don't just jump into steel stocks in general because we may all of the sudden get tariffs that could potentially boost domestic prices.

These moves have been tried before, and they have either fallen flat on their face legally, or haven't done much to change global market dynamics. Add in the capital-killing decisions that management teams have made over the years in this business, and that hardly makes for a sound investment thesis.

Do your homework.

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Tyler Crowe owns shares of Nucor. The Motley Fool recommends Nucor. The Motley Fool has a disclosure policy.