CYCLICALS
Traits
• Sales and profits rise and fall in regular, if
not completely regular fashion, as business
expands and contracts.
• Timing is everything. Coming out of a
recession into a vigorous economy, they
flourish more than Stalwarts. In the opposite
direction, they can lose >50% very quickly
and may take years before another upswing.
• Most misunderstood type, and investors can
lose money in stocks considered safe. Large
Cyclicals are falsely classified as Stalwarts.
• If a defensive Stalwart loses 50% in a slump,
then Cyclicals may lose 80%.
• It’s much easier to predict upswing, vs, a
downturn, so one has to detect early signs of
business changes. You get a working edge if
you’re in the same industry – to be used to
your advantage. Most important in Cyclicals.
• Unreliable dividend payers. If they’ve
financial problems, then they become
potential Turnaround candidates.
• Inventory build-up = bad sign. Inventory
growth > Sales growth = red flag. Inventory
build-up with companies having fluctuating
end product pricing causes larger problems.
• Monitor inventory to figure out business
direction. If inventory is depleting in a
depressed company, it’s the first evidence of
a possible business turnaround.
• High Operating Profit Margin (OPM) = Lowest
Cost producer, who’s got a better chance of
survival if business conditions deteriorate.
• Upswing favours companies with Low
OPM’s. Therefore, what you want to do is to
Hold relatively High OPM companies for long
term and play relatively Low OPM companies
for successful Turnarounds / cycle turns.
• The best time to get involved with Cyclicals
is when the economy is at its weakest,
earnings are at their lowest, and public
sentiment is at its bleakest. Even though
Cyclicals have rebounded in the same way 8
times since WWII, buying them in the early
stages of an economic recovery is never easy.
• Every recession brings out sceptics who
doubt that we will ever come out of it, who
predict a depression and the country going
bankrupt. If there’s any time not to own
Cyclicals, it’s in a depression. “This one is
different,” is the doomsayer’s litany, and, in
fact, every recession is different, but that
doesn’t mean it’s going to ruin us.
• Whenever there was a recession, Lynch paid
attention to them. Since he always thought
positively and assumed that the economy
will improve, he was willing to invest in
Cyclicals at their nadir. Just when it seems
it can’t get any worse, things begin to get
better. A comeback of depressed Cyclicals
with strong balance sheets is inevitable.
• Cyclicals lead the market higher at the end
of a recession – how frequently today’s
mountains turn into tomorrow’s molehills,
and, vice versa.
• Cyclicals are like blackjack: stay in the game
too long and it’s bound to take back all your
profits. Things can go from good to worse
very quickly and it’s important to get out at
the right time.
• As business goes from lousy to mediocre,
investors in Cyclicals can make money; as it
goes from mediocre to good, they can make
money; from good to excellent, they may
make a little more money, though not as
much as before. It’s when business goes
from excellent back to good that investors
begin to lose; from good to mediocre, they
lose more; and from mediocre to lousy,
they’re back where they started.
• So, you have to know where we are in the
cycle. But it’s not quite as simple as it
sounds. Investing in Cyclicals has become a
game of anticipation, making it doubly hard
to make money. Large institutions try to get
a jump on competitors by buying Cyclicals
before they’ve shown any signs of recovery.
This can lead to false starts, when stock
prices run up and then fall back with each
contradictory statistic (we’re recovering,
we’re not recovering) that is released.
• The principal danger is that you buy too
early, then get discouraged, and, sell. To
succeed, you’ve to have some way of
tracking the fundamentals of the industry
and the company. It’s perilous to invest
without the working knowledge of the
industry and its rhythms.
• Timing the cycle is only half the battle.
Other half is picking companies that will
gain Most from an upturn. If Industry pick =
Right, but Company pick = Wrong, then you
can lose money just as easily as if you were
wrong about the industry.
• If investing in a troubled industry, buy
companies with staying power. Also, wait for
signs of revival. Some troubled industries
never came back.
• If you sell at 2x, you won’t get 10x. If the
original story is intact or improving, stick
around to see what happens and you’ll be
amazed at the results.
Examples
• Auto, airlines, steel, tyres, chemicals,
aerospace & defence, non-ferrous metals,
nursing, lodging, oil & gas
• Autos: 3-4 up years, after 3-4 down years.
Worse Slump = Better Recovery. An extra
bad year brings longer and more sustainable
upside. People will eventually replace their
cars, even if put off for 1-2 years.
o Units of pent up demand – compare
Actual Sales vs Trend, ie, estimate of
how many units should’ve been sold
based on demographics, previous year
sales, age of cars on road etc.
o 1980-83 = sluggish economy + people
saving up, therefore pent up demand =
7mm. 1984-89 boom, sales exceeded
trendline by 7.8mm.
o After 4-5 years below trend, it takes
another 4-5 years above trend, before
the car market can catch upto itself. If
you didn’t know this, you might sell your
auto stocks too soon. After 1983, sales
increased from 5mm to 12.3mm and you
might sell fearing the boom was over.
But if you follow the trend, you’d know
the pent up demand was 7mm, which
wasn’t exhausted until 1988, which was
the year to sell your auto stocks, since
pent up demand from early 80’s got used
up. Even though 1989 was a good year,
units sold fell by 1mm.
o If industry had 5 good years, it means
it’s somewhere in the middle of the cycle.
Can predict upturn, not downturn.
o Chrysler EPS for 1988, ’89, ’90 & ’91
was $4.7, $11.0, $0.3 & Loss,
respectively. When your best case is
worse than everyone’s worst case, worry
that the stock is floating on fantasy.
• At one point, high yield Utilities were 10% of
Magellan’s AUM. This usually happened
when interest rates were declining and the
economy was in a splutter. Therefore, treat
Utilities as interest rate Cyclicals and time
entry and exit accordingly. Can also treat
Fannie / NBFC’s as interest rate Cyclicals
benefitting from rate cuts.
• In the Gold Rush, people selling picks and
shovels did better than the miners. During
periods when mutual funds are popular,
investing in the fund companies is more
rewarding than putting money into their
funds. When interest rates are falling, bond
& equity funds attract most cash. Money
market funds prosper when rates rise.
• In US /Europe insurance companies, the
rates go up months before earnings show
any improvement. If you buy when the rates
first begin to rise, you can make a lot of
money. It’s not uncommon for a stock to
become 2x after a rate increase and another
2x on the higher earnings that result from a
rate increase.
People Examples
• Make all their money in short bursts, then
try to budget it through long, unprofitable
stretches. Farmers, resort employees, camp
operators, writers, actors. Some may also
become Fast Growers.
PE Ratio
• Slow Growers (7-9x) < Cyclicals (7-20x) <
Fast Growers (14-20x)
• Assigning PE’s: Peak EPS (3-4x) < Decent
EPS (5-8x) < Average EPS (8-10x)
• Stock Pattern: 1990 EPS = $6.5, Price Range
= $23 - $36, PE Range = 3.6-5.5x. 1991 EPS
= $3.9, Price drops to $26. PE = 6.7x, higher
than previous year PE, that had higher EPS.
• With most stocks, a Low PE is regarded as a
good thing, but not with Cyclicals. When
Low, it’s usually a sign that they are at the
end of a prosperous interlude.
• Unwary investors hold onto their shares
since business is still good & the company
continues to show higher earnings, but this
will change soon. Smart investors sell their
shares early to avoid the rush.
• When a large crowd begins to sell, the Price
and PE drops, making a Cyclical more
attractive to the uninitiated. This can be an
expensive misconception. Soon, the economy
will falter and earnings will decline at a
breathtaking speed. As more investors head
for the exit, price will plummet. Buying
Cyclicals after years of record earnings and
when PE has hit a low point is a proven
method to lose ~50% in a short time.
• Conversely, a High PE may be good news for
a Cyclical. Often, it means that a company is
passing through the worst of the doldrums
and soon its business will improve, earnings
will exceed expectations, and investors will
start buying the stock.
2 Minute Drill
• Script revolves around business conditions,
inventories and prices.
• There’s been a 3 year slump in autos but
this year things have turned around. I know
that because car sales are up across the
board for the first time in recent memory.
GM’s new models are selling well and in the
last 18 months GM closed down 5 inefficient
plants, cut 20% labour and earnings are
about to turn higher.
Checklist
• Inventories: keep a close eye on inventory
levels, changes, and, the supply & demand
relationship.
• Competition: new entrants / added supply =
dangerous development, because they may
cut prices to capture market share.
• Know your Cyclical: if you do, then you have
an advantage in figuring things out and
timing the cycles.
• Balance Sheet: strong enough to survive the
next downturn? Can it outlast competitors?
Is capex on upgradation / expansion a cause
for concern? How much of a drag is it on
FCF? Is CF > Capex, even in bad years? Are
plant & machinery in good shape?
Portfolio Allocation %
• 10-20% Allocation
Risk/Reward
• Low Risk – High Gain; or
High Risk – Low Gain, depending on
investor adeptness at anticipating cycles.
• +10x / (80-90% loss)
• Get out of situations where Price overtakes
Fundamentals and rotate into Fundamentals
> Price
Sell When
• Understand strange rules to play game
successfully, because Cyclicals are tricky.
Sell towards the end of the cycle, but who
knows when that is? Who even knows what
cycles they’re talking about? Sometimes, the
knowledgeable vanguard sells 1 year before
any signs of decline, so price falls for no
apparent reason.
• Whatever inspired you to buy after the last
bust, will help clue you in that the latest
boom is over. If you’d enough of an edge to
buy in the first place, then you’ll notice
changes in business and price.
• Company spends on new technological
expansion, instead of cheaper expenditures
on modernizing old plants.
• Sell when something has actually gone
wrong. Rising costs, 100% utilization but
spending on capacity expansion, labour asks
for increased wages, which were cut in the
previous bust etc.
• Final product demand slows down.
Inventory builds up and the company can’t
get rid of it. If storage is full of finished
goods, you may already be late in selling.
• Falling commodity prices, Futures < Spot
Price. Oil, steel prices turn lower much
earlier than EPS impact.
• Strong competition for market share leads to
price cuts. Company tries cost cuts but can’t
compete against cheap imports.
The Peter Lynch Playbook
Twitter@mjbaldbard 7 mayur.jain1@gmail.com
