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What is a Cyclical Business?

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Some businesses make money by selling a lot of products to a lot of people. Others make money selling a few very expensive products to a few customers. Businesses are divided into stock sectors and stock industries; this allows investors and analysts to compare similar business types.

Before you invest in any business, you need to understand the business cycle which governs sales and investments. How does the company stay in business? What's its relationship to competitors? (What's its economic moat?)

One type of business worth understanding is a cyclical business.

What is a Cyclical Stock? What is a Cyclical Business?

A cyclical business is an enterprise in which revenue ebbs and flows based on a predictable business cycle. A cyclical stock is the stock of such a business.

The canonical example of a cyclical stock is an auto manufacturer such as Ford or GM. Think about how cars are sold. Every model year, the manufacturer comes out with a new version, probably a slight upgrade over the previous edition. The previous year's cars are sold at a discount, because who wants to buy a new 2015 car when a new 2016 car has just come out?

Ford's problem is that incremental yearly upgrades aren't free. You can get by with tweaking the way you build engines and frames and put things together a little bit, but after four or five or six or seven years, you'll have to retool the entire factory, and that costs millions and millions of dollars.

Every few years, Ford (and Chrysler and GM and Toyota and...) must invest billions of dollars in new and upgraded factories just to stay in business. If the business plans well and sets aside money every year, this isn't a bad thing (it's a normal cost of being in this particular industry, and it helps weed out competitors who can't match this cycle over the long term). Yet it also affects the quarterly numbers reported every three months. As capital expenses go up, profits go down and analysts rate the stock lower.

Hold that thought.

Why Do Stock Prices Fluctuate on Cycles?

Whenever you see a cycle in the stock market, assume that the market as a whole will move with that cycle. To paraphrase Warren Buffett, be cautious when others are exuberant and buy (good stocks) when others are pessimistic. This does suggest that counter cyclical stocks exist; when the economy in general is faltering, they soar. Sometimes your best strategy is to make countercyclical investments—trade against the direction of the cycle.

When Ford spends a cool billion dollars on a new factory and reports that it won't record any profits this year, people tend to sell the stock and depress its price. Sometimes it goes below the intrinsic value of the company. (The market can get really pessimistic if you look at it quarter by quarter.)

If GM announces that it's deliberately investing in the business to make more money next year, the year after, and the year after that, but as a consequence it won't pay dividends for a while (example made up), you'll probably see a dip in its price. It's almost as if pension funds and money markets and target date funds can't bear to show any quarterly losses, and so they shuffle their money around and churn stocks, trying to stay just ahead of these business cycles that you can predict in certain stock sectors.

Even if the board of directors of the company and its upper management have a good plan and a track record of successful decisions like this one, lots of parts of the market have no taste for long term planning. The incentive structures of funds and investment management companies and, yes, broker fees reward this short term thinking.

How to Make Money From Cyclical Stocks

Knowing the psychology of the market makes it a little easier to predict, but performing reliable discounted cash flow calculations on a stock with fluctuating free cash or owner earnings adds risk to your analysis. This makes a simple value investing buy and hold strategy more difficult.

At the same time, knowing that cyclical businesses have cyclical stock prices (periods of undervalued prices followed by periods of overvalued prices), you can buy when prices seem low and sell when prices seem high. This requires even more diligence and patience, and it requires even more self control than the "buy and hold forever" strategy.

To make a countercyclical analysis work, you must look into the stock's historical trends. How often does the company reinvest profit into operating expenses or take out loans? How long do they take to pay off? How does the market react?

It's easy to see when a stock price slides (financial indicators such as book value or debt and asset ratios help answer the questions "Is it undervalued?" or "How undervalued is it?"). You can't answer beforehand the question "What's the lowest this stock price will go?" If you're trying to time the market to get the absolute best price, give up now. You'll beat yourself up psychologically trying to chase every last percentage point of profit.

Predicting the high point of the stock is difficult too. There's no guarantee that the stock will ever reach an overvalued point before the next cycle of factory building begins. (That's the hope of the business's management, of course. Invest a lot one year to reap profits in subsequent years. Hope and reality are not always the same thing.)

To make money from a cyclical company, buy low and sell high and set yourself an acceptable profit threshold. (15% per year? 30% overall? Whatever makes sense.) When—if—the stock heats up, start selling. You may not reap your maximum potential profit, but if you're greedy, you'll find yourself paralyzed and losing out on great opportunities because you're scared to miss out on the best possible opportunity.

How Cyclical Businesses Manage Their Finances

Auto manufacturers and airlines aren't the only businesses which have cycles of investment. Intel is a good example of how to manage manufacturing cycles well and still provide consistent profits. Intel's manufacturing and research and development follow a tick/tock strategy. The first version of a new semiconductor (the "tick") offers something new: a smaller size, a faster clock speed, a new manufacturing process. It's mostly research, and the product is for early adopter customers who can afford to pay a premium for a new product.

The "tock" strategy is the next part of the cycle. It's a refinement of the new product. It's cheaper to make. It has better yields. It's a little cheaper, so they can sell to hundreds or thousands more times the customers.

Granted, Intel has a huge advantage over its competitors. Its size and cash reserves make it easy to invest in several fabs at once, refining the process. As well, the varying needs of computer chips in all sorts of devices make it possible to sell older chips for devices which need less power than the hot new smartphone.

In short, having multiple simultaneous product lines, each on its own cycle, moderates the annual hit to the business of investing all profits into one big factory every few years. Yet not every business dominates its industry as Intel does. Not every business is as large as Intel. Even so, Intel's strategy is no accident.

Should You Invest in Cyclical Businesses?

Does it make sense to pursue a countercyclical strategy? That depends on your appetite for investing risk, your investment plans, and the way you think about your stocks. If you're comfortable watching an investment for low points and high points to buy low and sell high, you can find good profits over the course of several years. If, on the other hand, you prefer simplicity investments, looking for a cyclical company such as Intel which manages its business cycle without prolonged periods of booms and busts may give you a chance to buy low and hold for a long time.

Ultimately it's not the cyclical nature of the business which provides the potential for profit. It's the fact that sometimes the market undervalues the long term ability of the business to generate earnings for its owners. You can often see this most dramatically in cyclical businesses, but it's present in all market sectors and industries. You can find it if you look.