Cyclicals have long been the most hated and unpopular stocks among both institutional and retail investors. One reason for this is the inherent volatility that comes with cyclicals. You have years of bountiful profits followed by years of agonizing losses, often back-to-back. The psychological pain of holding on to these volatile stocks, especially during the troughs, is usually too great for investors. Consequently, we see very emotional responses to the valuation of these stocks as they navigate through peaks and valleys. However, in markets, the opportunities are most splendid when the pain is greatest.
Cyclicals, if identified correctly, can be exceptionally profitable investments.
This white paper will discuss the most critical variables to look for in cyclical businesses and investments. While not exhaustive, it provides a framework that, if understood and applied, has the potential to offer exceptional returns to investors while minimizing psychological pain.
Supply and Demand
To start with, supply and demand are critical factors in the cycle. Ideally, we want to be in cyclical businesses where the supply and demand equation is more or less predictable.
Take, for instance, our investment in Greenbrick Partners. Greenbrick is a home builder in the Dallas-Fort Worth, Texas region. Positioned as they were, owning the majority of the lots in the area, they controlled supply. On the supply side, we knew how long it would take for them to build houses and get them to market. That was predictable. On the demand side, housing starts are driven by employment growth and household formation, both of which are slow-moving and predictable. It was straightforward to gauge where we were in the cycle and roughly how long it would last.
Such insights into supply and demand allowed us to identify our position in the cycle. In the case of Greenbrick Partners, we were at the beginning of an uptick that we estimated would last about 3-4 years. Greenbrick would be able to sell its inventory and lots and build homes at attractive prices for a while. This information allowed us to make an investment that more than doubled when we exited our position slightly over a year later.
Exit Costs
Supply cannot be absorbed quickly in many businesses, leading to high exit costs, and home building is a prime example. Once you build the houses, there is no easy way to eliminate the excess supply quickly. Since household formation or demand for these houses is relatively sluggish and predictable, complete absorption of this supply also takes many years. The same applies to other industries. For instance, blast furnaces, once built, will be operational for at least ten years. In cases where supply absorption is slow, the down cycles can be excruciatingly long. Therefore, understanding supply absorption rates is essential to avoid prolonged, painful down cycles.
Shortcut
However, there is a way to gauge our position in the cycle even when the supply and demand equation is largely unpredictable. This can be seen as a shortcut to finding the bottom.
When an industry goes through a trough, economic profits are the lowest for everyone; the most efficient or lowest-cost producers are either breaking even, slightly profitable, or losing a little money, while everyone else, the more inefficient competitors with thinner margins, are losing money hand over fist. At this point, we are typically at the bottom or trough of the cycle.
Eventually, the high-cost producers start cutting down on production as they can no longer sell at unprofitable prices. The most inefficient players are forced out of the industry, and the supply equation starts to recover. However, investors should be cautious and consider how long the supply will take to absorb.
The Winning Horse
Understanding supply and demand is essential, but which horse do you bet on when you’re at the bottom of the cycle? The answer is the lowest-cost producer. Lowest-cost producers are businesses with the thickest margins. When times are tough, the lowest-cost producers only have a headache, while others are terminally ill.
It’s straightforward to identify the lowest-cost producers. You can look at gross margins and operating margins across financials over time and compare them to their peers. However, it’s important to understand the reasons behind the cost advantages to ensure that low-cost leadership is maintained. Various factors, such as bargaining power over suppliers, economies of scale in production, technological edge, or a combination of all these, allow them to produce and sell goods at the highest margins. Investors should evaluate which competitive advantages allow for the low-cost position and if these advantages can be sustained over time.
Balance Sheet
Being the lowest-cost producer alone does not ensure success during the down cycle. You should also have a solid balance sheet. Over-leveraged businesses struggle when prices are low, margins are thin, but interest payments remain the same. Investors should seek the lowest-cost producer with a fortress balance sheet. A net cash profile is preferred, but a conservative amount of leverage is acceptable. Excessive leverage, however, puts even the most efficient producers at risk of failing to meet their debt obligations. There’s no point in betting on the fastest horse if it cannot run the entire race.
The Right Jockey
Intelligent leadership is akin to having the right jockey. A management team focused on aggressive expansion during good times will struggle when bad times roll around. Investors can look at capital expenditure levels during the up-cycle to gauge how the management thinks about cycles and cross-cycle profitability.
An intelligent management team should return more cash to shareholders, recognizing their cyclical business and avoiding adding excess capacity at the top. They should also maintain a conservative balance sheet. Incompetent management teams do the opposite: they add leverage and oversupply at the top, fail to return excess cash flow to shareholders, and create risks by taking on too much leverage. This failure to think full-cycle can even tank a low-cost producer. Hence, the management team becomes crucial; betting on the fastest horse is futile without the right jockey.
Price Matters
Valuation is a crucial part of any investment. A great business bought at a terrible price is still a lousy investment, and a poor business bought at a cheap enough price can still turn out to be a good investment. Although investors should focus on buying high-quality businesses, even the greatest business cannot make you money if you overpay for it. In investing, price matters.
To value cyclicals correctly, we cannot simply take bottom earnings and extrapolate them or top-of-the-cycle earnings and extrapolate them. This will lead to either too pessimistic or too optimistic valuations. Normalized earnings, or earnings of a business over time adjusted for cyclicality, are vital. We must normalize the down and up cycles and evaluate a base level of earnings for the cyclical business. Top-of-the-cycle and bottom-of-the-cycle multiples are both meaningless and should be avoided.
Moreover, we should ascribe the correct growth to cyclicals based on the average long-term growth rates of the industry. For instance, the steel industry will only grow at 2% over the long run. However, growth rates leading into the peak of the cycle could be well in excess of 5%, 15%, or even 20%. This is not representative of the entire cycle. We must consider earnings multiples, being cognizant of long-term, across-cycle growth rates. Failure to do so will lead to over- or under-valuation.
Home Stretch
In conclusion, lowest-cost producers purchased at cheap valuations and run by competent management teams can turn out to be wonderful investments over time. However, a robust understanding of all the factors outlined in this white paper is necessary to avoid typical cyclical investing traps.
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