What are cyclicals? By definition, cyclicals are businesses which have sales and profits that follow economic patterns. When the economy is good, the cyclicals’ performance is very good. When the economy is in depression, so is the fate for cyclicals. All the industries such as steel, paper producers, auto manufacturers, chemicals and airlines are subject to the wide swing, the ups and downs of the boom and the recession. It is a “well-known pattern, as reliable as the seasons.”
For value investors like us, we prefer stocks selling at very cheap prices. Several businesses can be called “cigar butts” as Warren Buffett described. It is like you are walking in the street, you find a cigar which has one puff left; you picked it up and smoked it, then threw it away. It is bad, but it is very, very cheap. That is why value investors often find a basket of stocks selling at low valuations, in terms of earnings multiples.
However, Peter Lynch's discussion in his book “Beating the Street,” low valuation seems not to be good regarding cyclical businesses. When the P/E ratios of those businesses are very low, it is a signal of the end of a prosperous interlude.
When the economy is good, both the top line and the bottom line show a very satisfactory record. But this will be reversed after sometime. The smart investors already sell out their shares to avoid the rush after the decline in earnings hits the stock price. At that time, the P/E drops because the price drops, which makes cyclicals look more attractive in valuation basis than before.
But Lynch stated that this was an “expensive misconception.” He commented: “As more investors head for the exits, the stock price will plummet. Buying a cyclical after several years of record earnings and when the P/E ratio has hit a low point is a proven method for losing half your money in a short period of time.”
So the low P/E ratio happens with cyclicals when the economy is at the bottom of its cycle. And when it passes its worst time, the business will soon improve. Normally it would continuously announce it exceeded earnings compared with Wall Street’s expectations, and all conventional funds will rush into the stock. Afterwards, the stock price has only one direction to go, which is up.
So what is the risk here? He experienced that investing in cyclical businesses is the game of anticipation. The danger happens when we are not patient enough, and we buy in too early, that leads to the discouragement and we decide to sell the stocks. In addition, it is the best if investors got knowledge of the industry, as well as the price movement of the commodities (such as copper, steel, paper, etc) relating to the businesses investors are looking into.
Last but not least, the key characteristics of cyclicals we should focus on are the ones that have strong balance sheets. The chance of cyclicals being in the red in terms of earnings is nearly certain; we just do not know when. That is why in order to survive in a downturn, the good cyclical businesses should have financial strength.
For value investors like us, we prefer stocks selling at very cheap prices. Several businesses can be called “cigar butts” as Warren Buffett described. It is like you are walking in the street, you find a cigar which has one puff left; you picked it up and smoked it, then threw it away. It is bad, but it is very, very cheap. That is why value investors often find a basket of stocks selling at low valuations, in terms of earnings multiples.
However, Peter Lynch's discussion in his book “Beating the Street,” low valuation seems not to be good regarding cyclical businesses. When the P/E ratios of those businesses are very low, it is a signal of the end of a prosperous interlude.
When the economy is good, both the top line and the bottom line show a very satisfactory record. But this will be reversed after sometime. The smart investors already sell out their shares to avoid the rush after the decline in earnings hits the stock price. At that time, the P/E drops because the price drops, which makes cyclicals look more attractive in valuation basis than before.
But Lynch stated that this was an “expensive misconception.” He commented: “As more investors head for the exits, the stock price will plummet. Buying a cyclical after several years of record earnings and when the P/E ratio has hit a low point is a proven method for losing half your money in a short period of time.”
So the low P/E ratio happens with cyclicals when the economy is at the bottom of its cycle. And when it passes its worst time, the business will soon improve. Normally it would continuously announce it exceeded earnings compared with Wall Street’s expectations, and all conventional funds will rush into the stock. Afterwards, the stock price has only one direction to go, which is up.
So what is the risk here? He experienced that investing in cyclical businesses is the game of anticipation. The danger happens when we are not patient enough, and we buy in too early, that leads to the discouragement and we decide to sell the stocks. In addition, it is the best if investors got knowledge of the industry, as well as the price movement of the commodities (such as copper, steel, paper, etc) relating to the businesses investors are looking into.
Last but not least, the key characteristics of cyclicals we should focus on are the ones that have strong balance sheets. The chance of cyclicals being in the red in terms of earnings is nearly certain; we just do not know when. That is why in order to survive in a downturn, the good cyclical businesses should have financial strength.
