3 hot sectors where shares are scarce

By Jim Jubak

Want to understand the current stock market rally?

It's simple supply and demand: When the supply of stocks goes down and demand stays steady, then prices go up. Thanks to the buyout boom and the current fashion for companies to buy back their own stock, there are fewer shares to go around today than there were a year ago.

That's the strongest argument, in my book, for believing that this rally has got a ways to go yet. And it's the reason you should be in this market rather than on the sidelines waiting for a dip or correction.

But if you really want to profit from the shrinking supply of stocks, don't spread your money out over the market as a whole. Instead, concentrate your picks in the industries seeing the biggest reduction in supply and where the supply squeeze is driving up prices the fastest.

I've got three sectors -- and three picks -- for you to look at: steel makers, railroads and fertilizer makers.

The incredible shrinking market

The supply crunch in the overall market is astounding.

First, thanks to buyouts that take public companies private and acquisitions that merge one company with another, the number of publicly traded stocks is shrinking. So far this year, according to Standard & Poor's, 217 publicly traded U.S. companies have gone private. With only 107 U.S. companies going public, that's a net loss of 110 stocks this year alone.

Second, even when companies stay public, they're buying back their own shares, reducing the number of shares trading in the public markets. Companies in the S&P 500 Index ($INX) set a new record for share repurchase in 2005, according to Standard & Poor's, buying back $325 billion of their own shares. That obliterated the old record, set in 2004, of $197 billion in repurchases. Total shares for the companies in the S&P 500 fell by about 4 billion in 2005.

In 2006, the S&P 500 companies proceeded to smash that record, spending $432 billion on buying back their own shares. And the pace has held steady in 2007. Standard & Poor's projects that companies will buy back another $400 billion in their own stock this year.

Add stock buybacks to buyouts and acquisitions and, Standard & Poor's estimates, a total of $1 trillion in stock will exit the public stock markets in 2007.

Gobble, gobble, gobble

The activity isn't spread evenly across the market, though. In some sectors, the race for market share has resulted in one company gobbling another, only, in turn, to be gobbled up itself. In the steel sector, for example, where Mittal Steel's acquisition of Arcelor created Arcelor Mittal (MT, news, msgs), the world's largest steel group, every producer that can is reaching for size. In March 2007, for example, United States Steel (X, news, msgs) bought Lone Star Technologies (LSS, news, msgs), creating, temporarily no doubt, the largest maker of steel tube in North America. That title had been held by Ipsco (IPS, news, msgs) thanks to its December 2006 acquisition of NS Group. That deal followed quick on the heels of the acquisition of Maverick Tube by Tenaris (TS, news, msgs) in October 2006 as Tenaris continued to build its global market share.

Each of these deals gave the price of stocks in the sector a boost. United States Steel, for example, paid a premium of about 40% to buy Lone Star Technologies. The deal valued Lone Star at about $1,500 per ton of steel-making capacity, according to CIBC World Markets. That was up from the $1,300 a ton that Tenaris paid for Maverick.

And that premium immediately set Wall Street analysts looking for the next buyout candidate. Many eyes settled on Ipsco, so recently an acquirer itself. Trading at about $130 a share at the time of the United States Steel/Lone Star Technologies deal, Ipsco hit $150 a share in just two weeks.

And up next . . .

Why so far (up 15%), so fast (in two weeks)? It's the magic of scarcity value. Ipsco was the last major tubular steel maker in the United States left as an acquisition candidate. If anybody wanted to build share in this segment, Ipsco was the only company to buy. So the bidding began even before there was the slightest sign of a bidder moving toward the table. And then, on May 3, SSAB Swedish Steel (SSABF, news, msgs) announced it would acquire Ipsco for $160 a share.

So who's next in steel? I like Steel Dynamics (STLD, news, msgs), a mini-mill producer that makes flat rolled steel out of steel scrap. The flat-rolled-steel market has been relatively depressed as the sector works through a drop in demand (slower domestic car sales) that had pushed up inventory. That business is bouncing back, and the company is looking at about 12% earnings growth in 2007 by my estimates. But what makes Steel Dynamics an acquisition candidate is the relative newness and efficiency of its mills, something of a rarity in the U.S. steel industry. Wall Street certainly thinks the company is in play. The shares moved up strongly on reports that AK Steel (AKS, news, msgs), a producer that shares many of Steel Dynamics' traits, was about to get a bid from Arcelor Mittal. No bid is ever certain until the check is cashed, but Steel Dynamics is showing enough improvement in its business to give the shares a reasonable safety net. I'm adding the shares of Jubak's Picks with this column.

Two other sectors where I think scarcity is adding to solid fundamental stories are railroads and fertilizer makers.

And then there were 4

Warren Buffett put the railroad sector in play on the news that his company Berkshire Hathaway (BRK.A, news, msgs) had accumulated big positions in Burlington Northern Santa Fe (BNI, news, msgs), Union Pacific (UNP, news, msgs) and CSX Corp. (CSX, news, msgs). (We're talking big -- 39 million shares in the case of Burlington Northern.)

This is a sector that has consolidated over the past few decades until the United States is down to just four major railroads: Burlington Northern, Union Pacific, CSX and Norfolk Southern (NSC, news, msgs). Add in the two Canadian railroads, Canadian Pacific Railway (CP, news, msgs) and Canadian National Railway (CNI, news, msgs), and that's about it for the sector. No wonder just about every one of these stocks is trading at a 52-week high. If you want to play along, you have to buy one of these. What they say about real estate applies to railroads, too: Nobody's making any more.

But actually they are. Beginning from a single 14.5-mile-long line that had been used primarily to haul salt in western New York during the 19th century, Genesee & Wyoming (GWR, news, msgs) expanded after railroads were deregulated in the 1980s to include 48 railroads in the United States and railroads in Canada, Australia, Mexico and Bolivia. The company now operates 6,800 miles of owned and leased tracks.

A buyout candidate?

The scarcity value of railroads has pushed up the stock price, which has enabled Genesee & Wyoming shares to weather a slowdown in traffic volume from the housing industry and in its Mexico operations. Despite slow revenue growth, the stock is hanging in near its 52-week highs. In this case, stock scarcity in a popular sector has been an insurance policy for Genesee & Wyoming shares.

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