Of late there has been some great deal of talk about Cyclical being bought when the Price to Earnings (PE) is at its maximum and sold when the PE is at its minimum. While the theory could be criticized in parts the general structure would hold well under almost all circumstances.

The problem with cyclical is that they are never a long term bet. So if some one was given Tata Steel by his father 10 years ago it has not made him very rich. On the contrary an investment into non-cyclical stocks has produced some outstanding results.

In India the general category of blue chips was defined as ACC, Tata Steel, Tata Motors, Tata Tea etc. It has changed but only to some extent. I have done some serious analysis which tells me that these companies were good only for certain periods of time but not for any one who wanted to hold a stock for 10 years. Cyclical need to be churned rather then held as long-term investments. You cannot buy these stocks for your children

The above chart shows that these cyclical have underperformed the general category of blue chips, While all these stocks are significantly up from their January prices it would hardly make any serious difference to their 10 years compounded annualized returns..

Commodity cyclical are based on the price of the underlying commodity The problem with steel, aluminum, cement and other Cyclical is that as the price of their end product rises a number of projects that were closed down earlier become viable. This releases a gush of new supply.  Rising commodity prices encourage entrepreneurs to start green field projects Banks and Financial Institutions that were earlier not disbursing loans become eager to advance as project viability increases

In 2001 Tata Steel traded at a PE of 50 times. After having gone up 10 times from there and well into the top of the steel cycle it trades at a PE of 5 times.

How many of us would have kicked ourselves for not buying Tata Steel in 2001. Well, had we bought Tata Steel in 1996 we would have kicked ourselves also. This is because while Tata Steel was up 10 times over the last 5 years it went down 70% between 1996 and 2003. Ditto with Tata Motors and ACC and any other commodity cyclical. Remember the kind of return that the chart is reflecting is in the backdrop of the great Indian structural boom.

Now commodities as a class trade within a range over the very long period. For example steel wire rods have traded at Rs 11,000 on the downside to Rs 29,000 on the upside.

When these steel wire rods were at Rs 11,000 companies producing them would have been in great financial distress or maybe a loss. As a result EPS would have been at the lowest or the PE’s at the highest. But as investors we ought to know that commodity prices could not fall much. The reason for this being:

n        As prices fall a lot of inefficient small and mid sized companies close down

n        This closure decreases supply of the commodity

n        Lower prices creates more demand for that commodity

n        As demand exceeds supply prices start moving higher.

When these companies start hitting their lows they should be evaluated on market cap and the replacement cost basis. In 2001 Tata Steel traded at a PE multiple of 50 times with a Market cap of Rs 2000 crores (US $ 500 million) and is presently valued at (US $===5 billion)  

On the other hand when Steel wire rods sell for let us assume Rs 29,000 the following sequence of events follow:

n        As prices rise a lot of inefficient small and mid sized companies start operations. They are commonly known as mini cement and steel, plants

n        This increases supply of the commodity

n        At higher prices people want less of that commodity as it becomes difficult to pass on higher prices.

n        This new capacity builds up and at one point in time the supply exceeds demand and prices start moving lower.

So in this case the PE is at its minimum. Thus commodity prices are inversely related to the PE of the stock.

At Rs 29,000 in our example above steel could remain for 4 weeks 4 months or maybe 4 years that is a case for debate and more so worry.

Now comes the toughest part just because a cyclical trades at a  low PE an investor should not sell it. The low PE is more like the alarm bell but in this case no one knows when the final bell will ring. A couple of days back we discussed Sesa Goa in the Our Stocks section and we decided that the stock should do well because it traded at a PE of 4.5 times FY 07. Now how low can you get from there?

Therefore a low PE is an indicative measure rather then a judgmental tool. It indicates that we are somewhere near the top. But from these levels investors can make more money by betting for the bull run to continue. The odds are against you though as we saw in May 2006.

Another way to look at cyclical stocks is to see their operating margin and RoE’s Nearer to the top cyclical will have a higher RoE and a very high operating margin. The higher operating margins and RoE are not items of strength but one of threat. When others see that a particular industry is making abnormal profits they try and get in also the industries themselves expand capacity leading to excess supply and lower prices. Now at this kind of an RoE any one would be interested to set up a steel plant and sooner rather then later the supply would outstrip demand. As usual that point is hardest to predict. Cyclical generally report RoE’s of 14% - 18%.

n        One cannot hold a cyclical stock for 10 years. It needs to be sold at the tops and repurchased at the bottoms.

n        Accurately predicting the tops and bottoms is a matter of chance rather then choice. 

n        Investing in cyclical commodities means keeping track of the London metal Exchange ( LME) rather then the Bombay stock exchange (BSE). Since a  crash at the LME precedes a fall at the domestic bourses.

n        For commodities one has to keep an eye on the Govt.'s import / export policies. A rise in import duties never gets a stock a higher multiple. This is because the market is never sure whether this import duty would not be reduced during the next budget.

That having said... some cyclicals are different.. Hindustan Zinc was available at Rs. 10  three years back .. I started buying when it was Rs. 50

It went to Rs. 1100 and now it is Rs. 600+ And i strongly believe that it would reach 2000 within next 2 years..

Not focussing on cyclicals would make u miss out on these opportunities...

Started Buying India Cements from Rs. 45 ... Now its 210.. My Tisco holdings have also doubed in last 3 years .. Bought ONGC at 700 ... with all rich dividends its 1200+ (touched 1500)

Everyone knows when the cyclicals are in downward trend - buy it then ...

And when the boom period finishes  u'll get some hints (not a whole lot though) and then u can exit... For eg. since Mittal bought Arcelor - steel cycle is not coming 2 end. Since new Zinc mines takes 2 yrs to come up - Zinc shortage cannot cool off ! .... we need to keep doing these checks ...

but u can make 10, 20 baggers easily if u are able to get a hang of it !

happy investing