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How Some Investors Make Big Money in Cyclical Stocks

Jan 17, 2017

In this issue:
» Is Inflation Ticking up Again?
» The IMF Cuts India's GDP Growth Forecast
» GST Delayed
» ...and more!
00:00
Sarvajeet Bodas, Research analyst

Cyclicals are the most misunderstood of all the types of stocks. It is here that the unwary stock picker is most easily parted from his money, and in stocks that he considers safe. - Peter Lynch

Do you remember your first rollercoaster ride? I sure do. I was as excited as any kid would be on his first visit to an amusement park.

I remember jumping in and strapping on the safety belt. The ride began. My heart was beating fast. My eyes were wide open as the train slowly climbed higher. The wind on my face felt great.

And then my excitement turned into fear...

I realised that I would soon be going down...at a much faster speed than I was going up.

I don't remember how high we were when I realised this. All I remember thinking was I did not want to be on that rollercoaster. It wasn't fun anymore. I closed my eyes and did not open them until the end. I pretended to love the ride but told myself I'd never ride a rollercoaster again. And I haven't.

Fear is not fun.

But it's certainly prevalent in the stock market, isn't it?

The excitement-to-fear rollercoaster ride is exactly what investors feel when they put their hard-earned money in cyclical stocks.

Why?

As Peter Lynch rightly points out, they are the most misunderstood stocks in the market. Many of them are large caps, which are easy to confuse with bluechips. So unwary investors think cyclicals are fairly safe bluechip-like stocks.

But they aren't.

Cyclicals, no matter how big or small, must be seen as a separate category.

As Richa explains in the latest Hidden Treasure recommendation...

  • Cyclicals are of two types.

    The first type are companies directly related to the economy - i.e. any contraction or expansion in the economy affects them. Auto companies, capital goods, and banks fall under this category.

    The second type of cyclical is a business where pricing, earnings, and cash flows are dependent on the demand-supply of their products or raw materials. Metals, sugar, and chemicals fall under this category.

So why should these stocks give investors the goosebumps? Here's Richa with the answer:

  • It is almost impossible to accurately predict the cycles for either of the two types.

    So, while a low PE ratio would be attractive for most stocks, it is not always true for cyclicals. When a cyclical stock's PE ratio is very low, it's usually at the end of a favourable period. This is because of the disproportionate expansion in the earnings in the upturn of the cycle.

    This is often a signal of cycle reversal. And once the cycle reverses, the stock falls quickly and the PE ratio adjusts higher.

This is why Peter Lynch said the worst time to buy a cyclical stock was when the past financial performance was at its best. In another words, when the trailing PE ratio of a cyclical stock is low, it usually means the stock is nearing the end of the cycle.

This is where investors get on the wrong ride. They think they are buying a cheap stock. Then the cycle turns and the price falls. They're stuck on a train going down fast, and it could be years before the cycle turns up again.

So how do some investors (including Peter Lynch) make big money on these stocks?

There are two methods. Pick the one you are more comfortable with.

The more common of the two is the timing method. Basically, you try to pick the bottom of the cycle and ride the stock all the way up to the top of the cycle.

Of course, you'll need to remember to sell at top as well!

This is very difficult to do. Even if you are successful, you will have to endure a rollercoaster ride on the way up. That's because the markets are wary of any sign of a change in the cycle.

Remember, everyone wants to sell at the top. So these stocks tend to react more to negative economic news than the rest of the market. This makes them extremely volatile even on the way up.

The second method is less popular but more effective. Here's what you should do...

  • Pick an industry that's coming out of a major capex binge, so that more capacity won't likely be added at a fast pace.
  • Avoid industries where competition from new entrants is heating up.
  • Identify the best companies in the industry using fundamental analysis.
  • Find stocks that cater to a large set of clients to avoid client concentration risk.
  • Narrow down the ones with the healthiest balance sheets and cost-conscious managements.
  • Eliminate those with debt to equity higher than 1.
  • Don't pay more than 1.5 times book value.
  • Invest for the long term (3-5 years) to let the cycle play out.

This is not an exhaustive list. But it is more than enough to place you head and shoulders above most investors.

We practice what we preach. Richa's latest Hidden Treasure recommendation passed all these filters and more.

The best thing about this company is that it has created a niche for itself and is moving towards becoming a non-cyclical company. She believes she has found a big winner.

You can gain access to Hidden Treasure here.

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------------------------------

03:10 Chart of the Day

Talking about cyclical industries, commodities are the first thing that come to our mind. Commodity prices can have a huge impact on inflation data as well. As per the latest wholesale price index (WPI), WPI inflation accelerated to 3.39% in December 2016 as compared to -1.06% during the corresponding month of the previous year. For November 2016, WPI stood at 3.15%.

The rise in WPI inflation is mainly on the back of rising global commodity prices and an unfavourable base effect.

Can Inflation Come Back to Haunt the Economy?

Fuel and Power index rose sharply (on YoY Basis) on the back of the recent decision by the Organization of the Petroleum Exporting Countries (OPEC) to reduce crude oil output. Even oil producers outside the group led by Russia agreed to reduce the output. The low base effect of last year also contributed to a sharp increase of fuel and power index.

Manufactured products inflation, which largely contributed to the uptick in December 2016 WPI came in at a 14 month high of 3.37%. However, food inflation has turned negative for the first time since August 2015 at -0.7% in December 2016 as against 1.54% in the previous month.

In the coming months, it looks like WPI could inch up and CPI might soften. The RBI is scheduled to hold the next meeting of the monetary policy committee on 8 February and is likely to keep a close watch on these numbers.

03:50

The International Monetary Fund (IMF) has cut its GDP growth forecast for India by a full percentage point to 6.6%. This is on the back of disruption caused by demonetisation. With this, India may lose the 'fastest growing major economy' tag to China in 2016-17.

In its World Economic Outlook (WEO) Update, the IMF said India is likely to grow 6.6% in FY17. The IMF also expects India's growth to pick up at a slower pace in FY18, at 7.2%, against its earlier estimate of 7.6%.

As per the IMF, the growth forecast trimmed for the current and next fiscal year primarily due to the temporary negative consumption shock induced by cash shortages and payment disruption associated with the recent currency note withdrawal and exchange initiative.

Earlier, the World Bank has lowered its economic growth forecast for India to 7% after taking into account the impact of demonetisation and the fall in private investments. Similarly, the growth projection by the Central Statistics Office (CSO) released earlier, has lowered economic growth to 7%. This is mainly due to an industrial slowdown and this doesn't include the impact of demonetisation.

With GST likely to be rolled out from 1 July 2017, it will be interesting to see how economic growth estimate pans out for FY18. Watch this space.

04:30

Talking about GST, as per the latest development, GST is set to be rolled out from 1 July instead of 1 April after the centre and the states struck a consensus on the contentious issue of sharing of administrative powers. The deferred implementation date gives some time for the industry to prepare after the shock of demonetisation. Immediate rollout of GST would have created disruption and discontinuity in the system.

What remains now are the rates for various goods and services which will be decided in the near future. The real benefit of GST comes from a 'level playing field'. A common floor tax across India means that the most efficient producer will win the consumer.

If you would like to dig deeper into the practical implications of GST, I strongly recommend you download Vivek Kaul's free report, What the Mainstream Media DID NOT TELL YOU about GST.

04:45

After opening the day in the green, the Indian stock market indices slipped into the red around noon time. IT, FMCG, and capital goods, stocks are leading the sectoral gains.

The BSE Sensex is trading lower by 37 points (down 0.14%) and the NSE Nifty is trading lower 11 points (down 0.13%). The BSE Small Cap and BSE Mid Cap indices are trading higher by 0.4% and 0.16% respectively.

04:55 Today's Investing Mantra

"A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Sarvajeet Bodas (Research Analyst).

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