Thursday, November 25, 2010

My take on investing in cyclicals

I never really paid much attention to cyclical companies before. I might have bought a cyclical stock or two (maybe more) when I didn’t know any better, but that’s it. With the recent General Motors IPO, however, I couldn’t help but get excited about valuing cyclicals.

Side note:   Although I’m interested in valuing cyclical companies, I have no interest in investing in GM’s stock. Warren Buffett once said, “Turn-arounds seldom turn.”  And while it’s true that GM has reduced costs, and management said that it’s committed to improving GM’s balance sheet, I will still rather wait and see if management actually does what it says. Sure, there’s a possibility that GM will create good value for shareholders, but there are lots of other opportunities out there.

Before I go on any further, please allow me to explain what a cyclical is (or at least what I think a cyclical is). Feel free to skip the next paragraph if you already know about cyclicals.

Cyclical companies are companies that really have their fortunes tied to the economy.  Sure, any company will do better in a period of economic boom as compared to a period of economic downturn, but cyclicals are especially sensitive to the economy, and can go from making astronomical profits during the good times, to making huge losses during recessions (We only need to look back to the recent great recession to see how fast we can go from boom to bust). Airlines, steel producers, and automakers are examples of cyclical companies.

In this article, I will be talking about some of the things I would think about when evaluating the investment appeal of cyclical stocks.

The P/E ratio

I remember reading in Peter Lynch’s book “Beating the Street” that for cyclicals, a low P/E ratio can be a bad thing, and a high P/E ratio can be a good thing. This is the case, as when a cyclical company has a low P/E ratio, it could mean that the company’s earnings has peaked and will rapidly decline once the economy takes a turn for the worse. On the other hand, when the cyclical company has a high P/E ratio, it could mean that the company’s earnings are finally on the road to recovery (this is the best time to invest in cyclical, as profits have a lot of room to rise before tumbling down again; when profits rise, the price of the stock obviously rises too).

Captain obvious side note: For regular stocks, you want to see low P/E ratios and not high P/E ratios, as the lower the P/E ratio the cheaper the stock.

So, if you’re planning to invest in cyclicals, get interested in them when they are just starting to recover from a recession (their P/E ratios should generally be high during this time), and avoid cyclicals when they have low P/E ratios and are reporting very good earnings.     

Financial strength

Due to their nature of doing extremely poorly in recessions, being financially strong is absolutely crucial for cyclical companies, as that will allow them to weather what could be very heavy losses during the bad times. Here are a few things that investors should look at when determining whether or not a company is financially strong:

The company should have a healthy amount of cash or liquidity on its balance sheet to keep its operations running, meet its debt obligations, make the necessary capital expenditures, and take care of any unexpected  expenses without loading up on debt to unsustainable levels, selling off key assets, issuing stock and diluting existing shareholders, or even going into bankruptcy.

The company shouldn’t have to make large, regular capital expenditures in relation to its operating cash flow, as this might result in the company having to either raise more money or skip making certain expenditures and take a hit to future profitability (which might require much larger expenditures to fix).

The company shouldn’t have too much debt on its balance sheet. Too much debt is, obviously, bad for any company, but it can be absolutely devastating for a cyclical, as not only will the cost to service the debt eat into profits during the good times, but it might even cause the company to rack up huge losses when the economy turns sour.

Being a low-cost producer is a great thing for a cyclical (well, it’s a great thing for any company), as it makes the negative impact a recession will have on the cyclical company’s earnings more manageable.

Average out earnings

It is useful to average out the earnings of a cyclical company over a period of time that’s long enough to cover an entire business cycle (I think that 10 years should generally be alright, but we should adjust the time period if we can get a significantly better coverage of the business cycle), as this will give us a midpoint figure that we can use to help us determine if earnings are at their cyclical highs or at their cyclical lows.

After you have found out what the average earnings of the stock are, you can compare the company’s current earnings to its average earnings. It can be a good sign if the company’s current earnings are significantly below its average earnings, as it could mean that profits are starting to get better (as mentioned in “The P/E ratio" segment, this is the best time to pick up a cyclical).    

By averaging out earnings and comparing it to the current earnings to see if current earnings are low, we will get a better picture of whether or not a cyclical company is on the road to recovery than if we were to look at the P/E ratio to see if it is high, but we can save a lot of time by looking at the P/E ratios and narrowing the list down to only cyclical companies that we think is worth researching (It’s during our research that we do things like try and get a better picture by comparing average earnings to current earnings, evaluate the company’s financial strength, and etc).

Side note: It is important to remember that while we should look for cyclicals with high P/E ratios or cyclicals that are reporting profits that are significantly below their average earnings, we need to make sure that the cyclicals we are valuing are reporting low profits because they are just beginning to recover from an economic downturn, and not because those companies are doing lousy because they have lousy fundamentals. We should also generally avoid cyclical sectors that currently have a high P/E ratio on average because a rise in the prices of the raw materials they use have wiped out most of their profits.   

Don’t buy and hold

Unlike those non-cyclical companies with good competitive advantages, honest and shareholder oriented management, and high returns on equity, we can't buy and hold cyclicals for the long-term, as it will usually result in us earning not very good returns. We want to buy cyclical stocks when their earnings are at cyclical lows, and sell cyclical stocks when their earnings are at cyclical highs (before the economy corrects itself, and the earnings and the stock prices of cyclical companies plummet).

I’m certainly no expert, but I think that if investors want to be prudent, they shouldn’t wait for the cyclical companies they have invested in to start reporting profits that are close to cyclical highs before selling, but should instead start selling once earnings reach about 3 quarters of its peak (and that’s at the latest; when it come to cyclicals, there’s no shame in taking your profits early).

Investors should also sell a cyclical once its earnings show signs of plummeting; common sense should, obviously, be applied when making this decision. Buying shares in a cyclical company that’s currently earning 5 cents but  can potentially earn 5 dollars at the peak of its cycle, and then selling those shares 6 months later because earnings have dropped from 6 cents to 5.5 cents obviously doesn’t make sense.

I believe that the returns you can get from investing in great companies at attractive or even fair prices, and holding on to them for the long-term will far exceed the returns you can get from buying and selling cyclicals. But it’s not every day you get an opportunity to invest in a great company at an attractive price. And while waiting for that opportunity to come by, we can consider investing in cyclicals, as it can be a good way to make some money.

If you have any questions, or have anything that you would like to add, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.