You Should Not Invest in Cyclicals – Here’s Why!

Dear friends, I have been busy preparing community support and gearing up for my second batch of students soon.

In the midst of doing so, a reader emailed me and asked about investing in cyclical companies. In my earlier days of investing, I dabbled my feet into cyclical stocks and I lost money. I lacked the necessary knowledge. I suspect many of my friends do not find success in cyclical companies as well. Everything I write below is hypothetical.

Here is my answer: 

Cyclical companies are tough to understand, and their earnings are sensitive towards the economy’s conditions. During an economic crisis, consumer confidence will get hit. Then, consumers and corporations will pull back and delay purchasing products from the cyclical companies. You do not know when the demand might be back.

To be frank, I have not seen any investors who are successful in cyclical industries consistently.

Some cyclical examples are:

(Table 1 – Potential Cyclical Companies)

One similarity for all these companies is their earnings tend to be very volatile. The good can be very good, and the bad can be very bad.

Micron Example

Extracted from Micron’s Investor Relations site, during the previous financial crisis, Micron’s previous profits turned into losses. As for some of the companies mentioned in table 1, their profit shrunk significantly during 2008 – 2010.

(Figure 1 – Micron Investor Relations)

Let us look at the latest share price movement of Micron and we try to deduce the cause of the share price decline.

Micron has declined more than 36% since its peak on 30 May 2018.

36%!

It is in net cash position, ROE of 45%, and operating profit margin of close to 50%. Micron is a huge company with its enterprise value of US$44 billion.

Isn’t these fundamentals fantastic? Is the market blind, then?

While most quantitative-focused investors may purchase more of Micron’s stocks, the prudent ones would look at the capital cycle of the industry to have a sense of the forward earnings. Historical financial results can tell us the track record however investors tend to buy businesses based on their forward earning capability.

Will the company continue to earn more in the next 12 months – or lesser?

This is the big question.

Micron sells memory and storage solutions for computing, mobile, and storage purposes. Think about the amount of data we generate from taking photos or videos, it is stored somewhere. It could be Samsung, Hynix or Micron’s products. In recent times, Micron did well because of huge demand from data centers. For companies in this industry, it is important to monitor the DRAM and NAND prices.

On 18 October, DRAMeXchange reported further declines in DRAM prices, close to 5%. This movement may potentially affect the future profits of Micron.

This caused jitters among Micron’s investors, which could possibly answer the decline in its share price. Currently, Micron’s EV/EBIT and PE is at 2.95x or 3.45x respectively.

Isn’t that incredibly cheap?

Big Mistake

Again, the mistake lies with using the historical results to value Micron. The job of forecasting earnings for cyclical companies is the toughest, it is something that I would not even attempt. For simplicity, I will use P/E to explain.

Using Micron as an example,

Share price = $39.76

EPS = $11.52

PE = 3.45x

What happens if Micron’s EPS drops by 50% in the next twelve months?

Share price = $39.76

New EPS = $5.76 ($11.52 / 2)

New PE = 6.9x ($39.76 / $5.76)

An investor may believe he is buying Micron cheaply, but the forward PE could be 6.9x instead of 3.45x. It is not as cheap as it seems!

Had the share price remained at around $60, the forward PE could be 10.4x ($60/$5.76).

For cyclical stocks, we do not assign a high price-multiple because of its earnings volatility.

Conclusion

This simple example of using Micron is to inform how earnings could change within a short period of time and it affects the forward valuations of the company.

The most important aspect of being an investor is to sleep well. Do not risk investing in a company where you have no visibility or certainty over its business performance. Unless I am from the industry, I would avoid industries totally. Some businesses are more unpredictable and difficult to analyse, why should we subject our time and effort to it? Our time can be spent in analysing simpler businesses. Simple can be good. We do not get rewarded for analysing difficult businesses, we get rewarded for purchasing companies that are within our competence. Perhaps, cyclical companies are great to buy before an economic recovery. I am terrible at forecasts, so I rather focus my time and effort at uncovering gems for myself and my community.

Are there companies that grow despite economic conditions? The answer is yes. Most people have a false impression of being an investor. An investor is not someone who dabbles in and out of many stocks without a focus, it is very tough to outperform the market in this manner. An investor is someone who spots companies that compound over 15 – 20% and they have a portfolio which they can hold for 5 – 10 years. Imagine the incredible amount of time that one can free up to do so many things? It’s your effort versus output/results. To me, that is the true form of investing.

All being said, there could be successful investors who invest in cyclical as well.  I am looking forward to my second batch of graduates soon!

Till next article!