Cyclical businesses are not generally the most attractive opportunities for value investors. They tend to have considerable top line volatility, a high level of fixed costs, and usually require significant maintenance capital expenditures. As a result, that steady cash flow and attractive balance sheet, two qualities many value investors seek in prospective investments, is not always present. Nonetheless, at certain valuation levels cyclicals can be quite attractive and can provide significant performance leverage for a broader portfolio.
The primary reason cyclicals can help juice portfolio returns is because of their incredible earnings power. Due to high fixed costs, when the top line is moving in the right direction, cyclical businesses that racked up a number of operating losses in recent prior periods can quickly find themselves generating large profits in subsequent periods, resulting in 2-3 baggers over the life of a cycle. This choppiness can make cyclical companies both attractive sell short and long candidates depending on how adept an analyst is at determining when sales and profits for these types of businesses are at cycle highs or lows.
One way of gauging cycle peaks is through deceptively low valuations. Mr. Market essentially says he thinks profits and margins are at cycle peaks and due to limited growth in future periods, is unwilling to pay much more than say 5.0x trailing EPS for a particular cyclical business. As a result, often times the best time to evaluate cyclical businesses from the perspective of a long investor is when valuations look expensive. Due to very low current/trailing profits, valuations during these periods can look quite high. In fact, a P/LTM EPS ratio may be well above 30.0x. This is more of a reflection of just how low earnings are relative to the overall cycle of the company as opposed to an exorbitant valuation assessed by Mr. Market.
For example, U.S.-based legacy airlines were worth a look in the summer of 2009. As some readers may recall, in the spring of 2009, H1N1 manifested itself worldwide, negatively impacting shares of a number of airlines. While just about every other stock was experiencing a substantial rally off March 2009 lows, airline stocks had some trouble keeping pace with the broader market. This was largely due to concerns regarding the impact of H1N1 heading into the critical summer travel season for airlines. As a result, a number of legacy airline stocks were caught in the doldrums during the summer of 2009.
Airlines are generally awful investments but at the right valuation, just about anything is worth taking a look at. This is also a good time to remind readers that it sometimes helps to distinguish from truly long-term holdings and those that have shorter holding periods. I generally find cyclicals to fall under the shorter holding period bucket (<2 years) mainly because the explosive growth in most industry cycles will last just about a year or so before that growth moderates and a fair valuation is achieved. Another benefit of investing in cyclicals is that it can also instill a bit more discipline in terms of developing very tangible catalysts to look for along with more rigorous valuation targets to help assess exit price targets.
I have observed that some investors tend to get complacent with non cyclical businesses and while I can appreciate and recommend the incorporation of new data to update valuation targets, the one benefit of cyclicals is that most of these tend to be mediocre businesses at best. This means it's generally hard to consider "this time it's different" themes when valuing companies like airlines and refiners and it's also hard to justify paying fair value for these businesses. Certainly, economic data relevant to these types of businesses can suggest that there's more upside and growth to drive operating profits but these types of businesses tend to be as mean reverting as one can find. This means as an investor, you can seize upon these types of companies when they are dirt cheap and won't also become complacent and try to stretch for returns by refusing to redeploy capital in other opportunities when capital return metrics (ROIC, ROA, ROE) seem too good to last and valuation levels seem way too cheap.
In the case of U.S.-based legacy airlines, the first step was to determine if they were cheap. Many of these carriers were quite cheap in that Mr. Market was pricing in very little operating profit growth or margin improvement past 2009. This observation could be seen by very high forward valuations. So while airlines were trading at very high P/LTM EPS (assuming they had earnings which many did not), even sellside estimates for 2010 and 2011 yielded high P/E valuations meaning most investors expected airlines to struggle to generate profits well into the future.
Airlines were also cheap on a P/B basis, not surprising as many cheap P/B companies signal major financial distress and at the time the world was just emerging from a deep recession and any chance of the airlines getting out of the slump was hindered by H1N1. So across two metrics—P/E and P/B—airlines were cheap but for very good reasons. So an investor could establish that airlines were cheap, but was the risk/reward skewed whereby an investor should establish a long position or just avoid the industry all together?
The nature of the airline business requires significant debt financing. This is a characteristic that is similar to a number of cyclical industries so when conducting my analysis, once I establish something is cheap, the next thing I want to do is find out how much rope a company has before it potentially finds itself on the gallows. In the case of airlines, I found that a number of investors were overlooking the relatively strong liquidity they had. In fact, in 2009 airlines had better liquidity profiles than they did heading into 9/11, which devastated the industry.
Further, there were actual financing transactions that were occurring in 2009. United Airlines, for example, raised $175 million in June 2009, demonstrating that there was investor appetite for risky debt. These transactions provided data to run scenarios regarding what specific terms were likely for other airlines that had to raise debt.
Running a number of very dire sensitivity analyses suggested that even if H1N1 knocked out summer travel and even if business travel did not return in a significant manner, a number of airlines had the ability to make it through to mid 2010. In addition, oil prices had dropped from about $140 per barrel in 2008 to about $60 or so in 2009. Even incorporating an increase to $80 per barrel gave the airlines of breathing room.
Another positive for airlines was that the industry was aggressively reducing capacity. Each company was reducing the number of flights run and essentially retiring substantial portions of their fleet which would reduce their overall cash drag. It seemed airline operators were collectively becoming more intelligent as many would forfeit, sell or transfer minor but expensive slots at airports where their competitive standing was rather poor. The end result would be much stronger pricing power across the industry.
By June and July of 2009, one could also observe the second derivative for airline travel, particularly high-ticket-priced business travel, drastically improving, meaning sales declines were decelerating on a year over year basis. This meant that if the airlines could make it through a challenging summer, current trends could really yield significant earnings power in 2010. Airlines were aggressively shrinking their cost base in terms of reduced capacity and the major drop in a key cost component—oil—could result in a tightly coiled enterprise, positioned to generate major operating profits once travel normalized beyond the impact of H1N1.
This is what largely happened over the next 12-18 months since the summer of 2009. The good thing is that because the market is a discounting mechanism, investors just about a year after the summer of 2009 were able to unload their shares at very attractive prices. The same phenomenon could be observed with U.S.-based refineries over the past 18 months and the template was very similar.
That's one reason developing some experience with cyclical businesses can benefit investors. The investment template is pretty similar allowing for a "rinse and repeat" approach across industries. My approach can be condensed into the following for cyclical industries:
1) Identify absolute cheap companies through P/negative EPS, high P/E multiples, high P/LTM CF multiples, cheap P/B or P/TBV.
2) Determine if the business is also at cycle lows through observation of poor operating profits, margins and poor return on capital return metrics.
3) Conduct a rigorous liquidity and credit analysis. Cyclical businesses can get cheap because their capital structures can result in bagels and we want to avoid those permanent losses of capital. Test the company's cash flow outlook and analyze the credit statistics and its liquidity profile. Determine if it can access the capital markets and what type of terms would be available. Read the credit agreements in the 8-Ks and run sensitivity analyses to assess how close a company is to tripping covenants. Having all of this information allows you to determine if there is indeed a margin of safety from a liquidity perspective and how much time you have for a reversion to the mean to occur.
4) If a company is cheap and seems to have sufficient liquidity, then focus on the cost structure. Determine if the company is making the right changes and if those changes are being implemented quickly enough to stem any current cash hemorrhaging. Sometimes businesses make changes that require significant capital expenditures which can be a net neutral to a net negative from the standpoint of a long investment because the time it takes to see any benefits from those investments could simply be too long. The company may be better served hoarding that cash for the time being and providing more liquidity and protection for the investor rather than making that long-term investment. The better the cost and cash management, the faster a business can usually turn around. This is because even if the top line does not return as dramatically as it had in the past, a tighter (smaller) cost structure can still provide the operating leverage to generate substantial cash flow and profits when the cycle does turn.
5) Identify trends that can result in a turnaround in operating performance. In the case of airlines, one could see a deceleration in the decline in aggregate air travel as well as business travel. This boded well for the profit outlook if that trend continued to improve.
6) If after all of these steps one could determine a significant margin of safety exists from both a valuation and liquidity perspective, and there are tangible cost and cash flow catalysts along with the potential for some top line growth, then conduct a valuation analysis based on the next 1-3 years. Forecasting is almost worthless, but I find it helps me to evaluate what I am assuming and if those assumptions are realistic. In the case of airlines, I did not want to assume oil prices would hover around $60 barrel by 2010 or 2011. Throw a range in your models to find out what conservative cash flow and EPS estimates can be projected for the next few years and then use a conservative industry multiple under normalized conditions to come up with a valuation range. If you are buying near the bottom of a cycle you could find that your valuation targets imply a price 100-300% above the current price.
So with all of that said, where can one find attractive cyclical companies these days? A number of traditional cyclical industries have experienced massive rallies over the past 6-24 months depending on the specific industry, and many of these companies now face the prospects of higher production costs and moderating sales growth. In some cases, participants of these industries may be very attractive shorts.
However, I think there are cyclical industries that warrant a look by long investors. One industry I have focused on in recent months is the old media sector. Most have left this industry for dead and while the long-term prospects are awful, I think U.S.-based regional/local newspaper companies, radio, and broadcast television companies have an attractive risk/reward over the next 12-18 months.
There's no argument that revenue for print media, radio and broadcasting television is on a long-term path to zero. However, I think that's widely known. In addition, I think investors that ignore these businesses solely for the deterioration in the top line are missing on a number of positive things occurring between the middle part of the income statement, cash flow statement and balance sheet. While not traditional cyclical companies, old media companies have executed a number of savings initiatives that have resulted in very lean cost structures, while the top line has in some cases reduced its precipitous decline.
More importantly, 2011 is expected to be a pretty weak year for ad sales relative to 2010 so there's very little reason to get excited about these companies. That's a good thing as these stock prices reflect investor apathy. However, investors that are focusing solely on 2011 are missing the big opportunity in 2012. In 2012, the U.S. Presidential election will take place. The Summer Olympics will also occur in 2012.
These two events should generate significant ad dollars and thus crank up earnings for a number of traditional media players. Market participants want no part of the sector in 2011 due to weak earnings driven by a weak top line but I expect as we get into 2012, market participants will want to find companies that have the most leverage to the election and Olympics. I suspect that many will take a close look at old media companies and find that despite the long-term out look, the 2012 outlook may be quite attractive. This should allow current investors in the sector to sell into fairly attractive valuations by mid 2012.
The primary reason cyclicals can help juice portfolio returns is because of their incredible earnings power. Due to high fixed costs, when the top line is moving in the right direction, cyclical businesses that racked up a number of operating losses in recent prior periods can quickly find themselves generating large profits in subsequent periods, resulting in 2-3 baggers over the life of a cycle. This choppiness can make cyclical companies both attractive sell short and long candidates depending on how adept an analyst is at determining when sales and profits for these types of businesses are at cycle highs or lows.
One way of gauging cycle peaks is through deceptively low valuations. Mr. Market essentially says he thinks profits and margins are at cycle peaks and due to limited growth in future periods, is unwilling to pay much more than say 5.0x trailing EPS for a particular cyclical business. As a result, often times the best time to evaluate cyclical businesses from the perspective of a long investor is when valuations look expensive. Due to very low current/trailing profits, valuations during these periods can look quite high. In fact, a P/LTM EPS ratio may be well above 30.0x. This is more of a reflection of just how low earnings are relative to the overall cycle of the company as opposed to an exorbitant valuation assessed by Mr. Market.
For example, U.S.-based legacy airlines were worth a look in the summer of 2009. As some readers may recall, in the spring of 2009, H1N1 manifested itself worldwide, negatively impacting shares of a number of airlines. While just about every other stock was experiencing a substantial rally off March 2009 lows, airline stocks had some trouble keeping pace with the broader market. This was largely due to concerns regarding the impact of H1N1 heading into the critical summer travel season for airlines. As a result, a number of legacy airline stocks were caught in the doldrums during the summer of 2009.
Airlines are generally awful investments but at the right valuation, just about anything is worth taking a look at. This is also a good time to remind readers that it sometimes helps to distinguish from truly long-term holdings and those that have shorter holding periods. I generally find cyclicals to fall under the shorter holding period bucket (<2 years) mainly because the explosive growth in most industry cycles will last just about a year or so before that growth moderates and a fair valuation is achieved. Another benefit of investing in cyclicals is that it can also instill a bit more discipline in terms of developing very tangible catalysts to look for along with more rigorous valuation targets to help assess exit price targets.
I have observed that some investors tend to get complacent with non cyclical businesses and while I can appreciate and recommend the incorporation of new data to update valuation targets, the one benefit of cyclicals is that most of these tend to be mediocre businesses at best. This means it's generally hard to consider "this time it's different" themes when valuing companies like airlines and refiners and it's also hard to justify paying fair value for these businesses. Certainly, economic data relevant to these types of businesses can suggest that there's more upside and growth to drive operating profits but these types of businesses tend to be as mean reverting as one can find. This means as an investor, you can seize upon these types of companies when they are dirt cheap and won't also become complacent and try to stretch for returns by refusing to redeploy capital in other opportunities when capital return metrics (ROIC, ROA, ROE) seem too good to last and valuation levels seem way too cheap.
In the case of U.S.-based legacy airlines, the first step was to determine if they were cheap. Many of these carriers were quite cheap in that Mr. Market was pricing in very little operating profit growth or margin improvement past 2009. This observation could be seen by very high forward valuations. So while airlines were trading at very high P/LTM EPS (assuming they had earnings which many did not), even sellside estimates for 2010 and 2011 yielded high P/E valuations meaning most investors expected airlines to struggle to generate profits well into the future.
Airlines were also cheap on a P/B basis, not surprising as many cheap P/B companies signal major financial distress and at the time the world was just emerging from a deep recession and any chance of the airlines getting out of the slump was hindered by H1N1. So across two metrics—P/E and P/B—airlines were cheap but for very good reasons. So an investor could establish that airlines were cheap, but was the risk/reward skewed whereby an investor should establish a long position or just avoid the industry all together?
The nature of the airline business requires significant debt financing. This is a characteristic that is similar to a number of cyclical industries so when conducting my analysis, once I establish something is cheap, the next thing I want to do is find out how much rope a company has before it potentially finds itself on the gallows. In the case of airlines, I found that a number of investors were overlooking the relatively strong liquidity they had. In fact, in 2009 airlines had better liquidity profiles than they did heading into 9/11, which devastated the industry.
Further, there were actual financing transactions that were occurring in 2009. United Airlines, for example, raised $175 million in June 2009, demonstrating that there was investor appetite for risky debt. These transactions provided data to run scenarios regarding what specific terms were likely for other airlines that had to raise debt.
Running a number of very dire sensitivity analyses suggested that even if H1N1 knocked out summer travel and even if business travel did not return in a significant manner, a number of airlines had the ability to make it through to mid 2010. In addition, oil prices had dropped from about $140 per barrel in 2008 to about $60 or so in 2009. Even incorporating an increase to $80 per barrel gave the airlines of breathing room.
Another positive for airlines was that the industry was aggressively reducing capacity. Each company was reducing the number of flights run and essentially retiring substantial portions of their fleet which would reduce their overall cash drag. It seemed airline operators were collectively becoming more intelligent as many would forfeit, sell or transfer minor but expensive slots at airports where their competitive standing was rather poor. The end result would be much stronger pricing power across the industry.
By June and July of 2009, one could also observe the second derivative for airline travel, particularly high-ticket-priced business travel, drastically improving, meaning sales declines were decelerating on a year over year basis. This meant that if the airlines could make it through a challenging summer, current trends could really yield significant earnings power in 2010. Airlines were aggressively shrinking their cost base in terms of reduced capacity and the major drop in a key cost component—oil—could result in a tightly coiled enterprise, positioned to generate major operating profits once travel normalized beyond the impact of H1N1.
This is what largely happened over the next 12-18 months since the summer of 2009. The good thing is that because the market is a discounting mechanism, investors just about a year after the summer of 2009 were able to unload their shares at very attractive prices. The same phenomenon could be observed with U.S.-based refineries over the past 18 months and the template was very similar.
That's one reason developing some experience with cyclical businesses can benefit investors. The investment template is pretty similar allowing for a "rinse and repeat" approach across industries. My approach can be condensed into the following for cyclical industries:
1) Identify absolute cheap companies through P/negative EPS, high P/E multiples, high P/LTM CF multiples, cheap P/B or P/TBV.
2) Determine if the business is also at cycle lows through observation of poor operating profits, margins and poor return on capital return metrics.
3) Conduct a rigorous liquidity and credit analysis. Cyclical businesses can get cheap because their capital structures can result in bagels and we want to avoid those permanent losses of capital. Test the company's cash flow outlook and analyze the credit statistics and its liquidity profile. Determine if it can access the capital markets and what type of terms would be available. Read the credit agreements in the 8-Ks and run sensitivity analyses to assess how close a company is to tripping covenants. Having all of this information allows you to determine if there is indeed a margin of safety from a liquidity perspective and how much time you have for a reversion to the mean to occur.
4) If a company is cheap and seems to have sufficient liquidity, then focus on the cost structure. Determine if the company is making the right changes and if those changes are being implemented quickly enough to stem any current cash hemorrhaging. Sometimes businesses make changes that require significant capital expenditures which can be a net neutral to a net negative from the standpoint of a long investment because the time it takes to see any benefits from those investments could simply be too long. The company may be better served hoarding that cash for the time being and providing more liquidity and protection for the investor rather than making that long-term investment. The better the cost and cash management, the faster a business can usually turn around. This is because even if the top line does not return as dramatically as it had in the past, a tighter (smaller) cost structure can still provide the operating leverage to generate substantial cash flow and profits when the cycle does turn.
5) Identify trends that can result in a turnaround in operating performance. In the case of airlines, one could see a deceleration in the decline in aggregate air travel as well as business travel. This boded well for the profit outlook if that trend continued to improve.
6) If after all of these steps one could determine a significant margin of safety exists from both a valuation and liquidity perspective, and there are tangible cost and cash flow catalysts along with the potential for some top line growth, then conduct a valuation analysis based on the next 1-3 years. Forecasting is almost worthless, but I find it helps me to evaluate what I am assuming and if those assumptions are realistic. In the case of airlines, I did not want to assume oil prices would hover around $60 barrel by 2010 or 2011. Throw a range in your models to find out what conservative cash flow and EPS estimates can be projected for the next few years and then use a conservative industry multiple under normalized conditions to come up with a valuation range. If you are buying near the bottom of a cycle you could find that your valuation targets imply a price 100-300% above the current price.
So with all of that said, where can one find attractive cyclical companies these days? A number of traditional cyclical industries have experienced massive rallies over the past 6-24 months depending on the specific industry, and many of these companies now face the prospects of higher production costs and moderating sales growth. In some cases, participants of these industries may be very attractive shorts.
However, I think there are cyclical industries that warrant a look by long investors. One industry I have focused on in recent months is the old media sector. Most have left this industry for dead and while the long-term prospects are awful, I think U.S.-based regional/local newspaper companies, radio, and broadcast television companies have an attractive risk/reward over the next 12-18 months.
There's no argument that revenue for print media, radio and broadcasting television is on a long-term path to zero. However, I think that's widely known. In addition, I think investors that ignore these businesses solely for the deterioration in the top line are missing on a number of positive things occurring between the middle part of the income statement, cash flow statement and balance sheet. While not traditional cyclical companies, old media companies have executed a number of savings initiatives that have resulted in very lean cost structures, while the top line has in some cases reduced its precipitous decline.
More importantly, 2011 is expected to be a pretty weak year for ad sales relative to 2010 so there's very little reason to get excited about these companies. That's a good thing as these stock prices reflect investor apathy. However, investors that are focusing solely on 2011 are missing the big opportunity in 2012. In 2012, the U.S. Presidential election will take place. The Summer Olympics will also occur in 2012.
These two events should generate significant ad dollars and thus crank up earnings for a number of traditional media players. Market participants want no part of the sector in 2011 due to weak earnings driven by a weak top line but I expect as we get into 2012, market participants will want to find companies that have the most leverage to the election and Olympics. I suspect that many will take a close look at old media companies and find that despite the long-term out look, the 2012 outlook may be quite attractive. This should allow current investors in the sector to sell into fairly attractive valuations by mid 2012.
