Navigating the cycle: The contrarian approach

Investing in cyclical companies is challenging, as these businesses are highly susceptible to external factors such as raw material prices, macroeconomic conditions, and government policies. Additionally, their profitability often suffers due to their substantial operating leverage and debt burden. Steel companies serve as a prime example of this cyclical nature. While their revenue may dip slightly during economic downturns, their profits are disproportionately affected. These firms often carry a significant debt load, and regardless of their size, they have limited control over market dynamics. So, what investment strategy should one pursue in this context? Historically, a contrarian strategy has proven effective for investors in cyclical companies. The timing of investment plays a pivotal role in determining eventual returns. This approach advocates investing in these companies during periods of low profitability, often resulting in high price-to-earnings (P/E) ratios . However, it is crucial to note that before considering this strategy, it is essential to ensure that the company is profitable and maintains relatively lower debt levels. Profitability and capital expenditure Steel companies tend to generate substantial profits and free cash flow during favourable economic conditions. However, these periods of efficient performance are typically followed by capacity expansion initiatives, requiring significant time and capital expenditure. Consistently generating free cash flows is challenging, and adverse conditions during downturns can pose risks. Nevertheless, once a company weathers the downturn, it can reap the benefits of efficiency during favourable market conditions, thanks to its prior capital expenditures. Therefore, investing in a steel company post-heavy capex in capacity expansion and low profitability can prove advantageous for investors. The table below shows profit after tax (PAT) and capex of steel companies over the last 10 years. It can be seen that periods of high profit are usually followed by periods of high capex. Tata Steel Year PAT(Rs cr) CFO(Rs cr) Capex(Rs cr) 2014 3,664 13,146 -16,066 2015 -3,956 11,880 -10,856 2016 2,043 11,455 -10,010 2017 -304