Cyclicals are the most misunderstood of all the types of stocks. It is here that the unwary stock picker is most easily parted from his money, and in stocks that he considers safe. - Peter Lynch
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| Cyclical Stocks in Intra, BTST, Client Mode, short Term |
But it's certainly prevalent in the stock market, isn't it?
The excitement-to-fear rollercoaster ride is exactly what investors feel when they put their hard-earned money in cyclical stocks.
As Peter Lynch rightly points out, they are the most misunderstood stocks in the market. Many of them are large caps, which are easy to confuse with bluechips. So unwary investors think cyclicals are fairly safe bluechip-like stocks. , But they aren't.
Cyclicals, no matter how big or small, must be seen as a separate category.
latest Hidden Treasure recommendation... Cyclicals are of two types.
The first type are companies directly related to the economy - i.e. any contraction or expansion in the economy affects them. Auto companies, capital goods, and banks fall under this category.
The second type of cyclical is a business where pricing, earnings, and cash flows are dependent on the demand-supply of their products or raw materials. Metals, sugar, and chemicals fall under this category.
So why should these stocks give investors the goosebumps? It is almost impossible to accurately predict the cycles for either of the two types.
So, while a low PE ratio would be attractive for most stocks, it is not always true for cyclicals. When a cyclical stock's PE ratio is very low, it's usually at the end of a favourable period. This is because of the disproportionate expansion in the earnings in the upturn of the cycle.
This is often a signal of cycle reversal. And once the cycle reverses, the stock falls quickly and the PE ratio adjusts higher.
This is why Peter Lynch said the worst time to buy a cyclical stock was when the past financial performance was at its best. In another words, when the trailing PE ratio of a cyclical stock is low, it usually means the stock is nearing the end of the cycle.
This is where investors get on the wrong ride. They think they are buying a cheap stock. Then the cycle turns and the price falls. They're stuck on a train going down fast, and it could be years before the cycle turns up again.
So how do some investors (including Peter Lynch) make big money on these stocks?
There are two methods. Pick the one you are more comfortable with.
The more common of the two is the timing method. Basically, you try to pick the bottom of the cycle and ride the stock all the way up to the top of the cycle.
This is very difficult to do. Even if you are successful, you will have to endure a rollercoaster ride on the way up. That's because the markets are wary of any sign of a change in the cycle.
Remember, everyone wants to sell at the top. So these stocks tend to react more to negative economic news than the rest of the market. This makes them extremely volatile even on the way up.
The second method is less popular but more effective. Here's what you should do...
Pick an industry that's coming out of a major capex binge, so that more capacity won't likely be added at a fast pace.
Avoid industries where competition from new entrants is heating up.
Identify the best companies in the industry using fundamental analysis.
Find stocks that cater to a large set of clients to avoid client concentration risk.
Narrow down the ones with the healthiest balance sheets and cost-conscious managements.
Eliminate those with debt to equity higher than 1.
Don't pay more than 1.5 times book value.
Invest for the long term (3-5 years) to let the cycle play out.
This is not an exhaustive list. But it is more than enough to place you head and shoulders above most investors.
Investing Mantra
"A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting." - Warren Buffett
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