February 11 2009 | Filed Under Stocks
Imagine being on a Ferris wheel: one minute you're on top of the world, the
next you're at the bottom - and eager to head back up again. Investing in
cyclical companies is much the same, except the the time it takes to go up and
down, known as a business cycle, can last years.
What Are Cyclical Stocks?
Identifying these companies is fairly straightforward. They often exist along
industry lines. Automobile manufacturers, airlines, furniture, steel, paper,
heavy machinery, hotels and expensive restaurants are the best examples.
Profits and share prices of cyclical companies tend to follow the up and downs
of the economy; that's why they are called cyclicals. When the economy booms,
as it did in the go-go '90s, sales of things like cars, plane tickets and fine
wines tend to thrive. On the other hand, cyclicals are prone to suffer in
economic downturns. (For more on the business cycle, see Recession: What Does
It Mean To Investors?)
Given the up-and-down nature of the economy and, consequently, that of cyclical
stocks, successful cyclical investing requires careful timing. It is possible
to make a lot of money if you time your way into these stocks at the bottom of
a down cycle just ahead of an upturn. But investors can also lose substantial
amounts if they buy at the wrong point in the cycle.
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Comparing Cyclicals to Growth Stocks
All companies do better when the economy is growing, but good growth companies,
even in the worst trading conditions, still manage to turn in increased
earnings per share year after year. In a downturn, growth for these companies
may be slower than their long-term average, but it will still be an enduring
feature.
Cyclicals, by contrast, respond more violently than growth stocks to economic
changes. They can suffer mammoth losses during severe recessions and can have a
hard time surviving until the next boom. But, when things do start to change
for the better, dramatic swings from losses to profits can often far surpass
expectations. Performance can even outpace growth stocks by a wide margin.
Investing in Cyclicals
So, when does it pay to buy them? Predicting an upswing can be awfully
difficult, especially since many cyclical stocks start doing well many months
before the economy comes out of a recession. Buying requires research and
courage. On top of that, investors must get their timing perfect.
Investment guru Jim Slater offers investors some help. He studied how cyclical
industries fared against key economic variables over a 15-year period. Data
showed that falling interest rates are a key factor behind cyclicals' most
successful years. Since falling rates normally stimulate the economy, cyclical
stocks fare best when interest rates are falling. Conversely, in times of
rising interest rates, cyclical stocks fare poorly. But Slater warns us to be
careful: the first year of falling interest rates is also unlikely to be the
right time to buy. He advises that it's best to buy in the last year of falling
interest rates, just before they begin to rise again. This is when cyclicals
tend to outperform growth stocks.
Before selecting a cyclical stock, it makes sense to pick an industry that is
due for a bounce. In that industry, choose companies that look especially
attractive. The biggest companies are often the safest. Smaller companies carry
more risk, but they can also produce the most impressive returns.
Many investors look for companies with low P/E multiples, but for investing in
cyclical stocks this strategy may not work well. Earnings of cyclical stocks
fluctuate too much to make P/E a meaningful measure; moreover, cyclicals with
low P/E multiples can frequently turn out to be a dangerous investment. A high
P/E normally marks the bottom of the cycle, whereas a low multiple often
signals the end of an upturn.
For investing in cyclicals, price-to-book multiples are better to use than the
P/E. Prices at a discount to the book value offer an encouraging sign of future
recovery. But when recovery is already well underway, these stocks typically
fetch several times the book value. For instance, at the peak of a cycle,
semiconductor manufacturers trade at three or four times book value.
Correct investment timing differs among cyclical sectors. Petrochemicals,
cement, pulp and paper, and the like tend to move higher first. Once the
recovery looks more certain, cyclical technology stocks, like semiconductors,
normally follow. Tagging along near the end of the cycle are usually consumer
companies, such as clothing stores, auto makers and airlines.
Insider buying, arguably, offers the strongest signal to buy. If a company is
at the bottom of its cycle, directors and senior management will, by purchasing
stock, demonstrate their confidence in the company fully recovering. (For more
on how to research insider activity, see Keeping An Eye On The Activities Of
Insiders And Institutions.)
Finally, keep a close eye on the company's balance sheet. A strong cash
position can be very important, especially for investors who buy recovery
stocks at the very bottom, where economic conditions are still poor. The
company having plenty of cash gives these investors more time to confirm
whether their strategy wisdom was a wise one.
Conclusion
Don't rely on cyclicals for long-term gains. If the economic outlook seems
bleak, investors should be ready to unload cyclicals before these stocks tumble
and end up back where they started. Investors stuck with cyclicals during a
recession might have to wait five, 10 or even 15 years before these stocks
return to the value they once had. Cyclicals make lousy buy-and-hold
investments.
by Ben McClure