They are all, presently, wildly profitable, and all have ROEs over 30% - the true mark of great, high quality, corporations. At the same time, neither do they seem incredibly expensive, with TTM PEs ranging from 7.2 for CF, to just 13.8 for JOY, and forward PEs ranging from 5.6 for CF to just 10.5 for JOY.
It almost befuddles the mind, how such great companies, some of them even predicted to grow earnings as much as 20-30% next year), can be trading at such low valuations. How could the market have missed these obvious opportunities? How can they even be trading as badly as they are?
This is possible because of something else all these companies share – they are all cyclical. They sell rather undifferentiated products that just happen to have become temporarily wildly profitable, as production temporarily lags demand.
And trading cyclical companies is very different from trading secular growth stories, or utilities, or financials, or a host of other special situations. Trading cyclical companies, especially doing so based on valuation multiples, is perhaps one of the easiest ways to fall into a value trap, much like the one I described in “Oil Refiners Are A Value Trap”. Here’s how cyclical companies are special:
Cyclical companies versus economic growth
Cyclical companies usually need strong economic growth, or at the very least, strong localized growth in their own markets. This is because cyclical companies, which mostly sell commoditized products, need a demand shock that can temporarily overwhelm any supply they can bring to the market. In the examples above, that demand shock came mostly from the overheating emerging markets and commodity sectors, something that’s now going colder.
Cyclical companies usually trade ahead of the economic cycle. For instance, U.S. home builders peaked in 2005, up to 6 months before the U.S. housing market peaked. They also bottom ahead of an upturn, which is why you saw some cyclical sectors bottoming out in January 2009.
Cyclical companies versus interest rates
Cyclical stocks usually start going up at the tail end of a reduction in interest rates, and during the first phase of a cycle of increases in interest rates by the central bank. As interest rate moves by the central bank are coincident with the economic cycle and cyclical companies trade ahead of the economic cycle, this is to be expected.
However, many cyclical companies will be much more influenced by factors of their own markets, than the general economic and interest rate environment. For these, the next two sections will be helpful.
Cyclical companies versus valuation multiples
This is where cyclical companies become value traps. One shouldn’t buy cyclical companies when their valuation multiples are low – that usually happens when the cycle’s peak is being reached, and it’s usually the worst possible time to buy them. Some value screening techniques, such as magic formula investing, sometimes come up with duds exactly because of this effect.
The other side of this is that one should buy cyclical companies right when it’s darkest - just before dawn - when multiples are horrible because there are little earnings to be seen, and there’s even the likelihood that a few of the players in the sector will go under. Obviously, care has to be taken in not buying those players that can, indeed, go under. The fact is that at the bottom of a cycle in a sector selling undifferentiated products, one of the things that removes supply capacity from the market are precisely the bankruptcies.
Three things can be done to choose the right cyclical companies at the bottom of the cycle:
- Choose those with the healthier balance sheets, to ensure survival;
- Choose the lowest cost players, and;
- If possible, buy a basket of the healthier players, so that a single mistake does not destroy the strategy of buying companies in a sector where difficulties will be evident.
Also, another great indicator of a cyclical top is when you see almost every competitor in a sector selling undifferentiated products and having a huge ROE. Such was the case with the companies that I opened this article with. You just need to think a bit – how can a high ROE for every company in a sector be sustainable, if it is possible for other companies to expand production and enter the sector with similar products in greater quantities? High ROEs are only sustainable in situations where there’s an anti-competitive moat (be it a brand, a technology, regulations, etc).
Cyclical companies versus the price of what they sell
At the top of a cycle there is not enough supply to go around. Prices have to be raised to ration demand. You hear of shortages. And that’s when you should sell the stocks of cyclical companies. You can be sure that pricing set in an environment where there are shortages won’t be sustainable as soon as the shortages go away – and the same goes for earnings earned while those prices are in effect.
And when should you buy them? You should buy them when a good part of the sector they trade in is seeing losses: when there are bankruptcies, and talk of factories being shut down and mothballed. Maybe even when prices go below variable costs and nobody puts a dime into further capacity expansion, all the while the closing of factories and the bankruptcies are taking away supply.
The companies named in this article all exhibit signs both of being cyclical companies, and of being near a cyclical top, given their very high ROEs, while selling products into markets with no barriers to entry. The apparently low valuations on these companies are thus somewhat deceptive. These cycles can go longer than expected, but given this reality, these companies are actually a lot riskier at today’s levels than either their profitability or valuation would let you know.
This is, however, not a call to short these companies, as much as a call not to buy them. To make a call on shorting these companies, you need specific intelligence in their sectors that tells you beyond any doubt that the deep earnings cuts are just around the corner - much like I did with the refiners.
The 3 boards below detail the valuation and financials on these 5 companies a bit more:
(Click to enlarge)