VD116 : Cyclicality: Opportunity or Pitfall?
In this issue:
Cyclicality: Opportunity or Pitfall?
Stock in focus: empty handed
The Rationality Test: S&P Global
What I’ve been reading these past few weeks
News from our companies
Doubler Portfolio update
Cyclicality: Opportunity or Pitfall?
As value investors, we typically buy companies where we believe the market has it wrong. This might be because investors see a temporary issue as far too severe and push the stock price down too low. Or it could be because the market simply doesn’t understand the business—or just doesn’t care.
You can often place cyclical companies into one of these two categories. While their issues usually aren’t real problems, but rather a normal market evolution, falling revenues are often seen as permanent—even though they are actually just the natural ebb and flow of supply and demand.
High demand and low supply drive up prices, which in turn lead to record profits and sky-high margins. The prevailing market sentiment at that point is always “this time is different,” believing we’re in a new normal and that profits for these companies will just keep climbing.
At that exact moment, the price-to-earnings (P/E) ratios of these companies look low, or at least they appear low based on forecasts for the coming years. But this is a result of those record profits, not a cheap stock price. What looks like a great opportunity based on earnings is often anything but.
High prices inevitably attract competition and trigger heavy investments in expanding capacity. Once all that extra supply hits the market, it often turns out to be larger than actual demand. A surplus is created, and prices start to plummet.
As a result of falling prices, margins and profits take a massive dive. For capital-intensive businesses, depreciation often pushes the bottom line straight into the red. Consequently, companies scale back investments, competitors vanish, and consolidation takes place. Capacity shrinks until it dips well below demand again, and the whole cycle starts all over.
At this stage, the P/E ratio is often sky-high, making it look like you are paying way too much for the company. Yet, this is exactly when it might be an absolute bargain, because the stock price has collapsed right along with the profits.
And that’s just the supply side of things, which can create cyclicality all on its own even if demand stays flat. Of course, managers aren’t silly enough to just repeat this supply cycle if demand never changed. Demand fluctuates too. In fact, high prices dampen demand, while low prices stimulate it. This amplifies the entire cycle even further.
On top of that, external factors like interest rates and new innovations can heavily impact demand.
Even though these cycles have existed for as long as I can remember (and have been able to study), the market continues to overreact to these waves. This isn’t because investors are stupid or have a short memory, but rather due to the intense psychological effects the situation has on them.
When Isaac Newton lost his fortune in the South Sea Bubble, he famously said:
“I can calculate the motion of heavenly bodies, but not the madness of people.”
Honestly, nothing is as dangerous to an investor as an Excel spreadsheet. It’s too easy to just extrapolate growth or declines into infinity. Fear and greed are constantly fighting for the steering wheel in an investor’s brain. Have you ever seen the animated movie Inside Out? In these films, we get a peek inside the brain of a young girl growing up and entering her teenage years. We see her emotions battling for control over the console. The film is so powerful that schools actually use it to explain feelings. As a father of three daughters, I also liked the five-minute short film about her first date—especially the glimpse into the father’s head.
In the investing world, emotions like fear and greed are in a non-stop battle with rationality. That fight happens inside the mind of every single investor. Simply recognizing this and reflecting on it helps us manage it.
With capital-intensive cyclical companies, it’s actually relatively straightforward. You can look at the ratio between the stock price and the tangible book value. If you can buy a company that owns ships, factories, or massive commodity reserves for half of its tangible book value, you can be pretty confident that you will come out ahead profitably.
These are exactly the sectors people typically think of: commodities, shipping, automotive... But make no mistake: cyclicality hides in most businesses, even though investors today seem to believe it no longer applies to semiconductors (chips).
The Pitfalls
One easily avoidable mistake when investing in cyclical companies is buying in when they carry too much debt. No one knows in advance how long a downturn in the cycle will last. When cash flow dries up, you want to be absolutely sure the company will still be standing on the other side of the cycle, rather than being forced into a fire sale just to service its debt. We look for companies with rock-solid balance sheets that can actually capitalize on those fire sales. Surviving is one thing, but coming out stronger is even better.
A mistake I still catch myself making is getting in too early. A downturn by itself isn’t enough. You really need to see capacity leaving the market—for instance, through competitors going bankrupt or getting acquired, or through heavy write-downs when companies shut down production.
The greatest danger is confusing cyclicality with a structural decline. There is always a chance a sector won’t recover at all because the world has moved on. From my own experience, I think of what happened to digital cameras with the arrival of the iPhone, or typewriters with the rise of the computer.
Investing in Cyclical Companies
Personally, I’ve been able to make some great returns with cyclical companies. Here are a few tips based on what I’ve learned:
Only focus on companies with rock-solid balance sheets.
Only invest in companies with low debt levels (yes, that’s technically the same as the first point, but it’s so critical I’m mentioning it twice).
Demand disciplined management teams that excel at capital allocation (for example, buying back shares at the bottom of the cycle, not at the peak).
Look at capital expenditures (CapEx) across the sector to gauge exactly where you are in the cycle.
Use normalized earnings and cash flows across cycles to determine valuation.
The same goes for growth: look across cycles, not just at the last few years.
Scale in gradually.
Scale out gradually.
Keep in mind that a cycle can last longer than you think. Make sure the upside potential is large enough so that even if it takes longer, you still walk away with a handsome profit.
