Thursday, 25 March 2010

Peter Lynch's 6 categories of stocks: Cyclical Stocks

The pitfalls and profits of cyclical stocks

February 22, 2010

Famous American investor Peter Lynch, in his great book ‘‘One Up On Wall Street’’, described how he split stocks into six different categories. In my previous two columns we covered sluggards, stalwarts and fast growers.

Now it’s time to move on to cyclicals which, along with the two categories we’ll cover on Wednesday and Friday, can offer lucrative opportunities. But they can also deliver crushing financial blows if you get them wrong.

If the sharemarket were a sporting competition, these stocks would be reserved for "first grade" players only. The market, though, is not like that. Beginners can quite easily lose their life savings on a cyclical stock bought at its peak, or on a turnaround that doesn’t turn around.

Most companies have a cyclical element to their operations. Even so-called defensive businesses benefit to some degree from a booming economy and suffer when things turn sour. But those particularly exposed to the ebbs and flows of a business cycle are known as cyclicals.

Retailers, vulnerable to fluctuations in discretionary consumer spending, are a good example. When unemployment or interest rates rise and consumers tighten their purse strings, they are hit hard. Shares in David Jones more than halved in the 14 months between December 2007 and February 2009. Then, as consumer confidence returned, they doubled over the ensuing 12 months.

There are also industry-specific cycles. Steelmaking and air travel can be deeply affected by movements in the supply and demand of their international marketplaces. The same is true of mining and related services groups, whose fortunes are much more tied to global economic conditions than to the local scene.

So, how does one spot a cheap cyclical stock?

A low price-to-earnings ratio (PER) often catches our eye at The Intelligent Investor. Yet this isn’t necessarily an opportunity with cyclical; it could be a trap. The fluctuating nature of a cyclical stock’s profits means they can appear superficially cheap, just as their earnings are about to fall off a cliff.

BlueScope Steel provided a classic example in 2007. Back then one of The Intelligent Investor’s researchers summed up his analysis like this: "The PER of 11.3 and the dividend yield of 4.4 per cent are deceptive and the stock would need to be a lot cheaper to offer a margin of safety. SELL."

BlueScope’s share price has since fallen by more than 75 per cent. Low PERs are not reliable indicators of value, especially when it comes to cyclical stocks.

To profit from cyclicals, you should seek them out at the point of maximum pessimism, when you’ve noticed signs that the underlying cycle is improving but the share price is still wallowing. Cyclicals aren’t the type of stocks you want to hold forever, though. And bear in mind that selling cyclicals too early can be uncomfortable.

Take my "Buy" recommendation on Leighton Holdings (something of a mix between a cyclical and a fast grower) at a low of $7.83 in May 2004. Less than two years later the stock was trading at $17.70 and I called on our members to take their 126 per cent profit (plus dividends) and run. Yet the stock price continued to soar throughout the resources boom, making my sell call look far too conservative, if not foolish.

A strong cycle can carry profits and stock prices further than you might imagine. But we must guard against greed becoming the dominant factor in any investment decision. While exiting a cyclical too early can lead to ‘seller’s regret’, getting out too late can be extremely hazardous to your wealth.

So one needs an understanding not just of the cycles affecting a stock but also of the expectations built into its share price at any point in time. When it comes to predicting cyclical turning points, I'm reminded of the quip that economists have predicted seven of the last three recessions – so don’t believe everything you read.

This article contains general investment advice only (under AFSL 282288).

Greg Hoffman is research director of The Intelligent Investor which provides independent advice to sharemarket investors.

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