Cyclicality, Leverage, “Near Death”
The three kinds of companies have two things in common: their earnings can swing wildly, and their stocks even more so. They can be like playing with fire, so they’re not for everyone. In fact, they’re not for most people, even though they usually lead the performance of a bull market in its first year or more. So you might want to stop reading here. Or you might keep on going just so you’ll know something more about how these stocks work, even if you won’t own them.
Cyclical companies are ones whose sales follow the business cycle up and down, like homebuilders, technology firms, metals miners or car companies. Sometimes investors will try to distinguish firms that deal in pure commodities, like lumber or basic chemicals, from those with other sources of value-added by calling the former “deep” cyclicals.
There is also a kind of cyclicality within an industry. Sometimes, the market leader has such a strong reputation for quality and service that the other market entrants end up being “overflow” producers–that is, they get orders only when the leader has run out of capacity and can’t supply new requests–despite having adequate quality and comparable prices. Even though the industry as a whole may not be particularly cyclical, it can turns out to be a roller coaster ride for the second-tier firms.
“Leveraged” companies are ones who have structured themselves in a way that small changes in sales, positive or negative, create large changes in profits. The leveraging comes in two forms, financial and operating.
Financial leverage means debt, either bank borrowings or bonds.
Operating leverage means high fixed costs (fixed costs are those that have to be paid, whether there’s any output or not; variable costs are those directly linked with the production of a specific item).
High fixed costs can result for a number or reasons:
1. it’s the nature of the business, like a semiconductor factory, a cement plant or a hotel;
2. the company’s plant and equipment is no longer state of the art and costs more to run than newer assets;
3. the plant and equipment isn’t configured in the best way.
Companies can mitigate the effect of leverage by entering into long-term arrangements, either formal contracts or informal agreements, that guarantee customers will always buy a certain portion of their output, though usually in return for a price concession. Japanese blast furnace steel mills, for example, have traditionally done this with their automotive customers. In most cases, I think, the industry leader does some form of this.
On the other hand, a company can choose to figuratively revel in its leverage and operate mostly/exclusively in the non-contract or “spot” market. It argues that the higher prices in good times more than offset the lower prices in bad. UMC, the Taiwanese semiconductor foundry, is a case in point. Twenty years ago, most gold mining companies operated this way, as well, but they also made sure they had no debt.
I think of “near death” companies as ones that depend on the kindness of strangers, and which are destined to go into bankruptcy in a world ruled by justice rather than mercy (or, what amounts to the same thing, government support for “strategic” industries). Computer memory chip makers would be a good example. PALM (a family member owns shares), pre its rescue by Bono, might be another. Too much leverage, management ineptitude, too much cyclicality are usually the causes of these companies’ problems.
When To Buy Them–and How Much
How much? In large amounts, never, in my opinion (a value investor would probably be more enthusiastic, though).
For most people, never may still be the right answer. For those with a relatively high risk tolerance, small amounts, among the top-tier companies, is probably best.
When to buy? These stocks are often the best performers during the first year or so of a new bull market. Their performance is typically in inverse order to their riskiness/cyclicality. Why? As you will be able to see from any historical record, these stocks as a group are pummelled in a down market, with the most highly leveraged doing by far the worst. The stocks are usually trading a steep discounts to asset value, with the second-tier companies at the lowest valuations. As the cycle turns, however, these “worst” companies (more precisely, those who don’t go into bankruptcy first) get disproportionately large sales gains (the industry leader runs out of capacity, so buyers have to turn to the same #2 and #3 they shunned a few months before) and the threat of bankruptcy recedes. So these stocks benefit not only from sharply increasing earnings, but also from a perceived decrease in risk.
Professionals typically buy the stocks of these volatile companies when they conclude that conditions can’t get any worse and sell them when they conclude that things can’t get any better. In effect, this means they buy when there are no earnings and no backlog of new orders and sell when the company is raking money in and the future looks great.
To me, it looks like now is the time.
Where Would I Look?
First, let me say I’m only beginning to do the research anyone would need before actually buying one of these, but I think three areas (the “usual suspects,” for me) are potentially interesting: hotels like HOT, MAR or IHG and casinos (I own WYNN already); semiconductor fountries, especially TSMC ; and industrial machinery companies like CAT or DE.
Usually I get worried about a stock symbol that spells a word–this isn’t a joke–because I think it shows top management is spending more time trying to be cute than running the business. But CAT is the start of the company’s name, and the management that picked HOT isn’t there any more. I do have unresolved/unresearched worries about both, though: CAT’s financing operation and HOT’s timeshares.
If you’re sticking to a plan of index funds + sector funds + individual stocks, you may decide that the cyclical area is too much trouble to deal with directly and find a sector fund to get exposure here instead.
What the Risk-Averse–That’s Almost Everyone– Should Avoid
“Risk averse” doesn’t mean conservative. It means expecting to be paid for taking risk and not embracing risk as an end in itself. Anyway, even the deepest value investors I’ve known would say to avoid industries in secular decline. That would certainly include airlines and newspapers. I’m sure you can come up with more.
I was listening to CNBC the other day and heard a reporter say a certain group of equity-oriented hedge funds had lost money over the past six weeks or so because they were long (i.e., they owned) high-quality companies and were short (i.e. had borrowed and sold, effectively betting the stock would underperform) low-quality companies. He didn’t know, but you should, if you’ve read this far, that the hedge funds in question were betting the market would continue to go down. Why? because low-quality, leveraged, cyclical companies outperform in the early stages of an up market.