Thread by @abhishec_s

Investing in Cyclicals

“It is here that the unwary stockpicker is most easily parted from his money” - Lynch

(thread)

Cyclicals are companies where the business performance and profits often swing wildly. This is usually accompanied by similar swings in their stock prices.

“The charts of cyclicals look like polygraph of liars”.

Timing is everythig here. We shoud ask why we can’t time the market, something almost everybody seems to agree to, while we can time cyclicals.

(I can’t do either. I don't even try).

One popular theory to time cyclicals is: Buy when multiples are expensive/profitability is low, Sell them when multiples are low/profitability is high. People also look at supply side: Sell when capex increases, Buy when nobody is putting up capacity.

Why do these stocks deviate so much from ‘fair’ value on either side? If investors understand the cyclicality, why don’t they just trade at average multiples on normalised earnings?

To trade at normalized earnings the company should survive the cycle. Cyclicals are usually assset/debt heavy. Many dont survive the downturn.

Even if you buy a little early, you can still lose a significant chunk of your capital and might be forced to exit at the bottom.

“The fact that the cyclical game is a game of anticipation makes it doubly hard to make money in these stocks. The principal danger is that you buy too early and then get discouraged and sell.”

At least over a full cycle the business should have generated ROEs above cost of capital. Otherwise its not a business, its charity.

Some investors who do buy cyclicals prefer cost leaders who have not lost money even at the bottom of the cycle.

If the cycle itself is very long, decades some times, you need to be mindful of new technologies and changing preference. The thermal power cycle for eg. cannot be expected to be as strong in future as in the past.

If you were a capital allocator (and as an investor you are one) ask whether you would want to own the business, without being able to trade the cyclicality.

When asset heavy companies go bust its usually the bankers (as assets are usually financed by debt) who are left holding the bill. The regualatory complexity itself can provide incentives to promoters that are not passed on to minority shareholders.

People who trade these stocks usually have deep working knowledge of the industry. You have to get both the buy and the sell timing absolutely right here and that is difficult if not impossible for outsiders.

For every one trade that the "outsider" get right there are probably ten others that he gets wrong.

Always be mindful of base rates.

Cyclicals are high risk high return trade (but given the risk, total capital deployed is low and hence total reutrn is low). And there in lies their allure.

“If you have the courage to go for a risky investment then try your hand at cyclicals” - Lynch

(end)