|
How to Invest into Cyclical Stocks
by Henry Lu
August 7, 2006
What is Cyclical Stock?
Many sectors are cyclical. The cyclical industry list includes semi
conductor,
auto, energy, home builder, mining, fertilizer, etc. The earnings of
those sectors have cyclical pattern of boom and bust over
certain period of time. The earning of cyclical stocks in those
sectors
show cycles, up and down. Like it or not, there are more cyclical
stocks in stock market than non-cyclical stocks.
Economics behind Cyclical Stocks
The reason for cyclical nature of business is free market competition.
Initially, a smart businessman would start up a company to produce a
hot
product. The selling price would be far above cost so that the owner
would be able to earn above average profit. The competitors then find
out and chase into the same market. As competition
becomes more and more severe, the profit margin would decrease or
even disappear. In the final phase of down cycle, lots of companies in
the same industry would lose money and go bankrupt. This would remove
lots of supply from the market and the business down cycle is hitting a
bottom.
As more and more supply being removed from market, the business cycle
would turn upward. the demand will catch
up with shrinking supply, and the product price and profit margin would
rise again. This kind of boom and bust business cycle would
continue
forever in many industries at different phases simultaneously.
Cyclical Stock Case Study
Table 1 is a hypothetical stock XYZ in a hypothetical cyclical
industry. The current XYZ stock price is $25 per share, and its PE is
36. Is it cheap or expensive? How should value investor approach this
stock and make money out of it?
Well, it is well known that low PE is cheap stock, and high PE is
expensive stock. An inexperienced investor would buy XYZ in 2001 at $80
price when its PE was low at 8 and sell at loss in 2006 at $25 when its
PE is high at 36. The investor would complain that "value investing"
does not work because he/she lost big in holding a low PE stock for 5
years.
Luckily, lots of value gurus already published money making method on a
stock like XYZ.
Table 1 - Hypothetical Cyclical
Stock
XYZ
Year
|
Cycle Phase
|
Earning per Share
|
Stock Price
|
PE
|
Price/Average
Earning
|
1996
|
bust
|
$0.5
|
$20
|
40
|
4
|
2001
|
boom
|
$10
|
$80
|
8
|
16
|
2006
|
bust
|
$0.7
|
$25
|
36
|
5
|
1996 -
2006
|
average
|
$5
|
|
|
|
Graham - Average Earning over 1 Business Cycle
Ben Graham is father of value investing. He clearly said in his book
that PE against past 1 year earning is not that important. The most
important earning is "average earning". In XYZ case, average earning
over 1 business cycle is $5 per share earning for past 10 years.
If we look at XYZ stock price against this averaging earning $5 per
share, making money is no longer that difficult. In 2001 when XYZ PE
was 8, its PE against average earning actually was pretty high,
at $80/$5 = PE of 16.
In 2006, XYZ PE against its average earning is $25/$5 = PE of 5. PE of
5 is pretty low
number although its published PE against past 1 year earning is high at
36.
This stock XYZ was "buy" in 1996, "sell" in 2001, and "buy" again now
in 2006.
"Buy low sell high" value investing method works, but it only works if
the investor knows how to use "average earning" based PE instead of
published PE as valuation guideline.
Our BlastInvest cyclical investment approach is mainly based on this
Graham's "average
earning" concept.
Lynch on Cyclical Stocks - Buy High PE Sell Low PE
Lynch approach is simply a copy cat from Graham's original
concept. Peter Lynch published his cyclical stock approach in his
books in a simple rule of thumb: "Buy High PE, Sell Low PE".
Peter Lynch's cyclical stock investment approach probably created more
confusion. But Lynch method would buy XYZ stock in 1996 and 2006
when it was at high PE and sell XYZ stock in 2001 when it was at low
PE.
Lynch method makes sense. Essentially, Lynch method is "buy" at bottom
of down cycle and "sell" at top of up cycle. Investors would make money
on XYZ by following Lynch's rule of thumb.
Peter Lynch mainly used this approach in 1980's on auto stocks.
Many auto stocks had trouble in early 1980's because of high oil price.
Chrysler even went bankrupt . It is interesting that after 1980, oil
had 20 years of bear market while Peter Lynch made a killing on auto
stocks. We believe in next 10 to 15 years, it is opposite, oil
and energy stocks will make killing and auto stocks will go to hell.
Final Thought on Cyclical Stocks and Low PE Stocks
The magnitude of earning cyclical change can be quite different in
different industries as well. For example, although commercial real
estate leasing is
cyclical business, commercial real estate rental earning is more stable
than many other
industries due to its practice of long term leases, sometimes in
10 to
20 years time frame. Once a 10 year lease is locked in, the landlord
pretty much can collect stable rent year over year without worrying too
much of business down side. On the other hand, nitrogen
fertilizer
business is extremely cyclical and the business can have several years
of losses and then several years of fat earning afterwards.
Because there are so much more cyclical businesses than non-cyclical
businesses, it is pretty risky for investors to jump into a stock just
because the stock published PE is below 10 without fully understanding
its business. Reported PE of 10 or below itself does not mean a
stock is cheap, sometimes the stock could be pretty expensive if it
happens to be the stock XYZ in 2001!
Webmasters and Ezine
Publishers:
Free professional
content - pre-licensed to you..
You are invited to use any or all of
these value investing articles in your publication or website.
The only requirement is the inclusion of the following, after each
article...
* Article by
Henry Lu of BlastInvest LLC, a premium investment newsletter publisher
in Connecticut. Visit http://www.BlastInvest.com
for FREE "how-to" investing assistance, web services and more.
|