With stock prices trending downward across the board, value investors are on the lookout for bargains among high-quality stocks that have solid long-term outlooks.
When screening for potential value opportunities at a time like now, when the stock market is on a downtrend but commodity prices remain high due to shortages, many value screens end up being full of cyclical stocks due to their low valuation ratios.
However, according to Peter Lynch, one of the most famous investors of all time who averaged a 29.2% annual return for the Magellan Fund between 1977 and 1990, cyclical stocks are normally value traps when they look particularly cheap. Thus, investors may want to proceed with caution on these stocks at the moment, keeping in mind Lynch’s observations on the rules of cyclical stocks.
Deceptive valuation ratios
One of the primary rules of cyclical stocks according to Lynch is their valuation ratios tend to indicate the opposite of what one would normally expect. With most other stocks, low valuation ratios correlate to being undervalued, while high valuation ratios mean the stock is overvalued. However, with cyclical stocks, low ratios normally correlate to the stock being expensive, while high ratios usually coincide with being cheap.
We do not have to look very hard to find evidence backing up this observation. Looking at the price-earnings ratio history of just about any cyclical stock compared to its stock price history, we can see that normally, the share price is highest when the price-earnings ratio is low and lowest when the price-earnings ratio is high (or when it cannot be calculated due to the company losing money). See the below chart for steel producer Nucor Corp. (NUE, Financial) as an example.
Once an investor has identified this trend, they may be lulled into thinking that profiting from cyclical stocks is easy, but the valuation trends of these stocks are more deceptive than they look. When business is good and valuation ratios are low, greed tends to take over logic, and many investors begin to believe this time will be different; that this time, the stock can keep going up forever, even if history has shown that is rarely the case. As Lynch writes in “One Up on Wall Street:”
“Cyclicals are the most misunderstood of all the types of stocks. It is here that the unwary stockpicker is most easily parted from his money, and in stocks that he considers safe. Because the major cyclicals are large and well-known companies, they are naturally lumped together with the trusty stalwarts.”
When the good times no longer roll
So why are cyclicals different from most other stocks? Why do their valuation ratios have a long and storied history of tricking investors into a false sense of security? The reason for this is because the earnings of cyclical stocks swing wildly up or down based on the overall economy and macro demand for the particular commodities they sell.
“A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion,” wrote Lynch. “In a growth industry, business just keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again.”
When times are good and a cyclical company experiences a bumper year, its earnings will skyrocket, resulting in low valuation ratios as the market is hesitant to assign higher ratios to a stock that investors know will eventually go back down. In a bad year, earnings will take a nosedive so sharp that even a selloff will still leave the company with high valuation ratios.
Unwary stockpickers can easily be parted with their money when it comes to cyclical stocks because they see good earnings results and mistakenly believe the increases can last forever.
However, the truth is that someday, the good times will no longer roll, and turning a profit from cyclical stocks is mostly dependent on correctly timing the market to seal in profits before things turn sour. Lynch notes that it is in cyclical stocks more than any other type of investment that you really need some sort of edge in order to be successful, such as working in the industry you are investing in.
Do not stay in the game too long
Aside from choosing the wrong times to buy and sell cyclical stocks, another reason why many investors find it difficult to make money with these stocks is because they end up holding on to them for too long. Perhaps they choose to hold the stock longer than they originally intended because it went down and they are hoping for a recovery. They might also be staying for a hefty dividend payout.
Since cyclical stocks will always come back down, though, holding them for the long term is a dangerous trap to fall into. As Lynch wrote, “Cyclicals are like blackjack: stay in the game too long and it's bound to take back all your profit.” If you hold from the bottom to the top and then back to the bottom again, you have not really made any money (aside from perhaps dividends).
