The Ups And Downs Of Investing In Cyclical Stocks

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