Cyclical Stocks: What Goes Around Comes Around

Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5

Cyclical stocks are the ones that rise and fall with the economy. Aluminum, steel, paper, autos, chemicals, airlines. When business is booming, these companies print money. When the economy tanks, they get crushed. Back and forth, reliable as the seasons.

But here’s the thing. Everything you know about regular stocks works backwards with cyclicals. And that’s what makes them dangerous and profitable at the same time.

The Backwards Logic of Cyclicals

With most stocks, a low P/E ratio means cheap. Good. You want to buy that.

With cyclicals? A low P/E ratio often means you’re about to get wrecked. When a cyclical has a low P/E, it usually means the company is at the peak of a good run. Earnings are high. Business looks great. Everything seems perfect. But the smart money is already heading for the exits.

Then the economy turns. Earnings drop fast. The stock falls. Investors who bought because of that “cheap” P/E ratio just lost half their money.

Now flip it around. A high P/E ratio on a cyclical can actually be good news. It means earnings are at their worst. The company is passing through the bottom of the cycle. Things are about to get better. That’s when fund managers start buying.

Lynch puts it simply: buying a cyclical after several years of record earnings and a low P/E ratio is a proven method for losing half your money in a short time.

The Danger of Buying Too Early

The trickiest part of cyclicals is timing. Wall Street is always trying to get ahead of the next cycle, anticipating the recovery earlier and earlier each time. This turns cyclical investing into a guessing game.

Lynch says the main risk is buying too early, getting discouraged while the stock sits there doing nothing, and then selling right before the rebound. If you don’t have a working knowledge of the industry, whether that’s copper, aluminum, steel, or autos, you’re guessing. A plumber who follows the price of copper pipe has a better shot at making money on Phelps Dodge than some MBA who thinks the stock “looks cheap.”

But Lynch always thinks positively. He assumes the economy will improve no matter how bleak the headlines. And when things seem like they can’t get worse, that’s when cyclicals start recovering. His principle: unless you’re a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.

Phelps Dodge: The Copper Play

Phelps Dodge is a copper company. Lynch recommended it in 1991, and the stock went nowhere the entire year. But a stock going nowhere isn’t a reason to dump it. Sometimes it’s a reason to buy more.

In January 1992, he reviewed the story again. He called his plumber, who confirmed that the price of copper pipe was going up. Then he called the company’s chairman, Douglas Yearly.

Here’s why Lynch liked copper. There’s a lot of aluminum in the earth’s crust, about 8 percent. It’s common and easy to extract. Copper is scarcer. Mines run out. They flood. They close. You can’t just add another shift like a factory making toys.

Environmental regulations had shut down many smelters across the country. Fewer competitors meant more business for Phelps Dodge, which still had plenty of smelting capacity.

On the demand side, every developing country in the world wanted better phone systems. Traditional phones need miles of copper wire. Unless all these countries were going to put a cell phone in every pocket (unlikely at the time), copper demand was going up.

Lynch checked the balance sheet. Phelps Dodge had $1.68 billion in equity and only $318 million in net debt. This company wasn’t going bankrupt no matter what happened to copper prices. Many weaker competitors would close their mines and go home before Phelps Dodge even had to worry.

He also looked at Phelps Dodge’s other businesses. Carbon black, magnet wire, truck wheels, and a gold mine in Montana. These side businesses earned less than $1 a share in a bad year but could earn $2 in a decent year. On their own, they might be worth $10 to $16 a share. With the stock at $32, you were basically getting the copper business for almost nothing.

The basic math on copper was simple. Phelps Dodge produced 1.1 billion pounds a year. Every penny increase in the price per pound added about 10 cents a share in earnings after taxes. If copper went up 50 cents a pound, earnings would improve by $5 a share.

Lynch didn’t claim to know where copper prices would go. But he figured copper was cheap because of the recession, and it wouldn’t stay cheap forever.

General Motors: The Stumbling Giant

People think of GM as a blue chip. Lynch says it’s really a classic cyclical. Buying it and holding for 25 years is like flying over the Alps. You might enjoy the view, but the hiker who goes up and down gets a lot more out of it.

In 1991, GM stock was down 50 percent from its highs. Showrooms were empty. Dealers were playing card games to pass the time. Everyone assumed GM was finished. The Japanese had won the car war. Game over.

Lynch saw something different.

He looked at GM’s businesses beyond U.S. car sales. European operations were profitable. GMAC, the financing arm, was doing well. Hughes Aircraft, Delco, and Electronic Data Systems were all solid. If GM could just break even on U.S. cars, it could earn $6 to $8 a share from everything else.

The company was closing plants. Painful for workers, but it meant GM was finally cutting costs. And it didn’t need to win the war with Japan. Even if its market share shrank from 30 percent to 25 percent, that was still bigger than all the Japanese automakers combined.

Lynch also used a powerful indicator: pent-up demand. Using data from a Chrysler publication, he tracked how many cars and trucks should have been sold each year versus how many actually were. By the end of 1993, the country would have about 5.6 million units of pent-up demand. That meant a boom in car sales was coming around 1994 to 1996.

The telling detail? The very week Lynch reached his conclusion, several GM cars won major awards, including the Cadillac that critics had been trashing for years. The trucks looked good. The mid-sized cars looked good. Since GM’s reputation could hardly get worse, all the surprises would be happy ones.

The Cyclical Lesson

Cyclical stocks require you to think backwards. Buy when things look terrible. Sell when things look great. Make sure the company’s balance sheet can survive the downturn. And have the patience to wait for the cycle to turn.

It sounds simple. It’s not easy. But Lynch argues that if you understand the industry and can read a balance sheet, you’ve got a real edge over the investors who just look at a P/E ratio and think they’ve done their homework.

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