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How to invest in cyclicals

Profiting from cyclicals requires a combination of vigilance, patience and enterprise. Of course, you can take the indirect route as well.

How to invest in cyclicals

In the tricky world of stocks, investing in cyclicals is even trickier. Unlike secular-growth non-cyclical businesses, cyclicals aren't long-term buy and hold. You can't expect them to organically build wealth. Of course, as the Indian economy itself has done well over the long term, even cyclicals have turned into long-term compounders, but as the economy matures, this may not be the case. Let's see how to profit from cycles then.

KEY TRENDS TO TRACK

GROWTH IN REVENUES: At the start of an upcycle, revenues start to witness growth. They start to fall as the downcycle approaches.

OPERATING INCOME AND MARGIN: Most cyclical companies are asset-heavy. Irrespective of the changes in revenues, their fixed costs remain the same. Hence as revenues jump, the company starts reporting high operating profit and margins. This could signal a reversal in cycle.

DEBT POSITION: Being asset-heavy, cyclical companies can take substantial debt for capital expenditure to meet the anticipated demand. Typically, at the peak of the cyclical, one can find them to be neck deep in debt. For instance, during the 2014 commodity bust, steel companies were heavily indebted. New capex announcements, along with new debt, tend to mark the start of an upcycle.

PLAYERS IN THE INDUSTRY: Before a cycle peaks, new players tend to enter the market in pursuit of higher profits and chase volumes through competitive pricing. As the cycle reverses and heads towards the bottom, weak or non-serious players tend to exit the market. Thus, the number of new players at a given point in time could also act as a gauge of where we are in a cycle. Sectors like steel, cement and housing finance have seen consolidation in recent years.

UTILISATION OF CURRENT SUPPLY: Companies generally go for further expansion only after they have utilised the current capacity. Keeping an eye on the existing capacity additions helps. For example, during the 2007-09 upcycle, utilisation levels of cement companies were more than 85 per cent. These have hovered around 70 per cent in the past few years.

HOW TO ASSESS VALUATIONS

P/B, NOT P/E: The classic P/E ratio doesn't tell us much about the valuation of cyclicals. At the start of an upcycle, when the earnings are still low, a run-up in stock prices can artificially inflate the P/E. Similarly, during downcycles, it may not be valid due to net losses or could be very high due to meagre profits. The P/B ratio helps assess the valuations better as it captures the asset-heavy nature of cyclicals.

EV TO EBITDA: This metric solves the problem of using the P/E ratio while also capturing the earnings. Enterprise value (market cap + debt - cash and equivalents) captures the value of the whole firm. When we divide it by EBITDA, or operating profit, we get the payback period if the entire company were to be acquired. Obviously, the lower the period, the better.

WHEN TO BUY AND SELL

  • If you have patience and tolerance, you can buy cyclicals when they are down in the dumps. Then wait for the cycle to turn. It would be worthwhile to go with quality names in this space that have robust financials. Once they seem to have peaked out, you can book your gains.
  • If you are market savvy and keep a track of market trends, keep looking for cyclical shifts, as is currently the case with many sectors. As the cycle starts recovering, you can buy cyclicals and exit them when the cycle seems to be reversing.

BE CAUTIOUS
Do understand that there is always a risk of going wrong with reading a cycle. Not to forget the several unprecedented factors that can derail any sectoral move. Allocate only a small portion of your portfolio to cyclicals. The majority of your portfolio should be in evergreen, secular-growth businesses.

For full analysis of various cyclical sectors, see:
- State of cyclicals: Automobiles & ancillaries
- State of cyclicals: Banking & finance
- State of cyclicals: Crude Oil
- State of cyclicals: Capital goods
- State of cyclicals: Construction & infrastructure
- State of cyclicals: Metals & Mining
- State of cyclicals: Real Estate