Tasty Scraps

By Eric J. Fry

We Americans excel at producing waste…lot’s and lots of
waste.

China buys some of it. The specific sort of "waste" that
China buys is scrap metal. We probably can’t export enough
of this stuff to plug our trade deficit…but we might
export enough of it to boost the fortunes of scrap metal
companies.

It is a perfect trade alliance; America is the world’s
largest scrap metal exporter, while China – no surprise –
has become the largest importer. In 2003, the Asian
juggernaut became the first country ever to import over $1
billion of U.S. scrap metal. Thanks largely to China’s
voracious appetite for scrap metal, prices are booming and
scrap metals companies worldwide are feasting on the trend.

"Companies dealing in scrap have seen their prices soar,"
reports Donald Straszheim of Straszheim Global Advisors,
"But they are still relatively unknown…and will continue
to be a beneficiary of the China growth story.

One beneficiary of the scrap metal bull market is Metal
Management, Inc. (Nasdaq: MTLM), which describes itself as
"one of the largest full service metals recyclers in the
United States, with approximately 40 recycling facilities
in 13 states." Half a world away, Australia’s Sims Groups
Limited (Sydney: SMS), the world’s largest scrap metals
company, is also surfing the scrap metal bull market.

Without going into exhaustive detail, these two companies
collect industrial scrap, as well as consumer scrap like
wrecked autos and broken washing machines, then dump the
stuff into massive shredders that, in the words of Metal
Management, "quickly breaks the scrap into fist-size pieces
of ferrous metal." At the end of all this bumping and
grinding and shredding, the metal recyclers end up with
various forms of scrap metal that they sell to steel mills,
foundries, secondary smelters and metals brokers.

Over the last couple of years, metal recycling has
resembled a kind of industrial alchemy – converting junk
metal into increasingly precious steel scrap. "For the
fiscal years of 2000, ’01, ’02 and ’03, the average annual
rate of Korean HMS pricing was around US$30 per metric
tonne (mt)," the Sims Group reports, "yet in fiscal 2004
this leapt to US$165mt."

Not surprisingly, profits in the sector are soaring. Sims
recently reported in its fifth successive year of earnings
growth – "50% up on last year’s then-record profit," the
company’s annual report beams.

"All global business units produced record results," gushes
CEO Jeremy Sutcliffe, "An unprecedented escalation in
ferrous prices in the second half more than offset the
negative impact of the dollar’s appreciation and higher
freight rates. Prices rose on the back of surging global
steel production and higher steel prices, triggered a
largely by a buoyant Chinese economy."

The improving fortunes of companies devoted to the scrap
metal industry have not been overlooked by investors. As
the nearby chart shows, the shares of Metal Management have
tripled over the last 18 months, while those of Sims Group
have more than doubled.

But notice that the share price moves are only modestly
higher than the near-doubling of benchmark scrap metal
prices. In fact, some grades of scrap metal have more-than-
tripled over this time frame.

Net-net, these stocks are much higher than they used to be,
but their valuations remain as shoddy as a rusty old Ford
Fairlane.

Sims sells for about 10 times estimated 2005 earnings,
while yielding nearly 4%.

Metal Management, with a PE ratio of less than 7, garners
even less respect from investors. The stock yields 1.1%.
Evidently, investors fear that scrap prices could plummet
just as quickly as they have soared.

"But the China-steel story is far from over," Straszheim
predicts. He suspects the lofty scrap prices may be with us
for a while, thanks to a rapidly expanding Chinese steel
industry that now accounts for about 30% of world steel
production.

And production will need to expand even more if the country
is to meet its ambitious infrastructure-development goals.
For example, investment in China’s railways will likely
total $12 billion this year.

"Beijing wants to add 100,000 km to the existing 74,000 km
of rail lines by 2020," says Straszheim. "China is building
out a rail grid (north-south, east-west) to lift economic
growth inland, and to facilitate the development of natural
resources inland as well. This will require lots of iron
[and] cement…"

The Sims Group, for one, is eager to lend a hand…and
expects to do so very profitably. The Group anticipates
record earnings again this year. "Steel prices in North
America remain at record levels and consequently demand for
ferrous raw materials continues to be high. The same is
also true of demand in Asian markets with Chinese buying
strong, and shortages of ferrous units, particularly pig
iron, very apparent…

"We remain confident that steel production and demand in
China will remain firm," the company boldly states. "We see
continued demand in most major markets, including the USA
where high steel prices continue to lead to high steel mill
utilization rates and strong raw material requirements."

Past performance is no guarantee of future results, of
course, but the scrap metal industry’s recent performance
suggests that future results might not be too shabby. We
would not dare to predict that the glittering performance
of scrap metal stocks will continue…

But we are prepared for the possibility. [Ed. Note : It’s
undiscovered, it’s cheap, China wants it, and inflation
makes it go up…Outstanding Investments specializes in
opportunities like this. Here’s OI’s report on oil:

E-Day

Did You Notice…?
By Eric J. Fry

If bond investors are talking so bearishly, why are they
walking so bullishly?

The vast majority of professional investors and economists
SAY that they expect bond prices to fall (and yields to
rise) over the next few months. Yet, the folks who actually
buy and sell these things exhibit no such bearishness.

Indeed, by most quantifiable measures, bond investors are
VERY bullish.

The implied volatilities on 10-year Treasury-note options,
for example, have dropped to multi-month lows, a phenomenon
that often signals intermediate-term tops in bond prices.
As the nearby chart clearly shows, the current readings on
option volatility are well below the two prior "spike lows"
that coincided precisely with the two prior peaks in bond
prices.

The correlation between option volatilities and bond prices
is no mystery. Since volatility readings reflect the
mindset of market participants, these readings also
function as a valuable contrary indicator.

Here’s why: Volatilities tend to rise as traders become
fearful and tend to fall as traders become confident and
complacent. (This is similar to the VIX Index of option
volatilities on stocks). But bond yields tend to do the
opposite – they rise when most bond investors become
fearful, and tend to fall when investors become fearless,
or overly complacent.

Therefore, since the current option volatility readings on
10-year T-note options reflect very little fear, bond
prices seem ripe for a decline.

Unlike the two prior lows in option volatility readings,
this particular one has persisted for several weeks. The
ultimate sell off might, therefore, be more severe than the
prior two…

We’ll be watching.

And The Markets…