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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 | 10,824 | -8,508 |
| 2018 | 17,564 | 8,023 | -7,520 |
| 2019 | 9,187 | 25,336 | -43,037 |
| 2020 | 1,172 | 20,169 | -14,067 |
| 2021 | 8,190 | 44,327 | -6,444 |
| 2022 | 41,749 | 44,381 | -8,798 |
| 2023 | 8,075 | 21,683 | -24,217 |
JSW Steel
| Year | PAT(Rs cr) | CFO(Rs cr) | Capex(Rs cr) |
|---|---|---|---|
| 2014 | 388 | 2,594 | -5,744 |
| 2015 | 1,720 | 7,876 | -6,513 |
| 2016 | -501 | 6,897 | -5,162 |
| 2017 | 3,454 | 7,888 | -4,500 |
| 2018 | 6,113 | 12,379 | -4,991 |
| 2019 | 7,554 | 14,633 | -11,176 |
| 2020 | 3,919 | 12,785 | -12,831 |
| 2021 | 7,873 | 18,831 | -12,490 |
| 2022 | 20,938 | 26,270 | -10,068 |
| 2023 | 4,139 | 23,323 | -14,289 |
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PAT is profit after tax CFO is cashflow from operating activities |
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The counterintuitive nature of P/E ratios
Generally, buying a company with a lower P/E ratio is considered a bargain, as it implies a lower stock price relative to earnings. However, with cyclical stocks, a low P/E ratio might convey a different story altogether.
Earnings for a steel company can vary significantly from one quarter to another, but the market often lags in adjusting stock prices accordingly. Consequently, the P/E ratio of a steel company may appear high not due to a high stock price but rather due to low earnings per share. In numerous instances, the P/E ratio of the stock has declined substantially despite minimal price fluctuations, primarily due to increased earnings.
For instance, on June 30, 2016, Tata Steel traded at Rs 31 with a P/E ratio of 29. Subsequently, the P/E ratio began to decline while prices rose. On October 1, 2018, the P/E ratio dropped below 10, with a price of Rs 58, yielding an annualised price return of 33 per cent. During the same period, JSW Steel achieved an annualised price return of 53 per cent. Similar patterns can be observed in other time periods, including the period between 2021 and the end of 2022.
This implies that when evaluating the P/E ratios of steel companies, one must examine historical data to discern whether a high P/E coincides with a decline in prices. Thus, a high P/E ratio might indicate an attractive investment opportunity, while a low P/E could signal the stock's overvaluation.
Conclusion
The contrarian approach has a successful track record with cyclical companies. However, it's important to acknowledge that this strategy may not work universally for all cyclical firms at all times. Besides the unpredictable nature of business cycles, company-specific factors also play a significant role. Therefore, investors are strongly advised to conduct thorough due diligence before investing. For further insights into cyclical stocks, you can refer to our comprehensive coverage on the topic here .
Suggested read: A cycle of stocks
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