Why I'm buying one of America's most hated sectors

Investors could make big returns over the next few months buying steel stocks at current levels

Steel companies are down 20%-plus over the past six months...

That shouldn't surprise most investors. As regular readers know, companies that produce steel used for building skyscrapers, cars, bridges, and power lines are among the greatest "boom and bust" assets in the world. They soar and crash as the global economy fluctuates. The price rises when investors expect growth. It falls when things slow down. And with most global economies slowing down lately, steel stocks have been falling...

But things are about to change... In fact, investors could make big returns over the next few months buying steel stocks at current levels. Let me explain...

As you can in the chart below, steel stocks – as measured by the Market Vectors Steel Fund (NYSE: SLX) – have trailed the S&P 500 by 23 percentage points over the past six months.

Steel stocks are suffering from fears of a global economic slowdown. Most of Europe is in a recession. China's economy has slowed from 12% GDP to less than 8%. And the U.S. economy is barely growing at all... Unemployment is still high and manufacturing has tailed off significantly in the past few months.

Sure, it looks dire out there – especially if you believe the negative headlines you read every day. But the last time we saw a global slowdown like this, it turned out to be the buying opportunity of a generation.

During the 2009 stock market crash, SLX fell below $25. Back then, most steel stocks traded below seven times earnings. One year later, the index jumped 140% to $65.

I don't expect the triple-digit gains we saw when steel stocks rallied from their super-depressed lows three years ago. But with most governments ready to do whatever it takes to "goose" the economy, steel stocks look oversold here.

I expect most steel companies to outperform the markets over the next 12 months. But my favorite way to play this sector is through shares of Steel Dynamics (NASDAQ: STLD), one of the largest steel companies in North America. With a market cap of $2.6 billion, it pays a much higher dividend and has stronger operating margins than competitor U.S. Steel (NYSE: X, Stock Forum). It's also much cheaper and expected to grow earnings faster than steel giant Nucor (NYSE: NUE).

Steel Dynamics trades at just eight times forward earnings. That's a 30% discount to the S&P 500. Excluding 2009, the company is trading at its lowest price-to-book and price-to-earnings valuation in more than seven years.

Over the next two years, Steel Dynamics is expected to grow earnings by more than 50% annually. This is the average estimate provided by 21 research firms covering the stock. Even if their estimates are off by half, the stock is still incredibly cheap based on price-to-earnings growth.

Steel Dynamics pays a 3.3% dividend. The payment is easily covered by earnings and cash flow. That's 40% higher than the average S&P 500 company. With most high-yielding sectors like utilities and consumer staples trading near 52-week highs, income investors may turn their attention to this undervalued stock.