Investing in cyclicals: Look before you leap! - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Investing in cyclicals: Look before you leap! 

A  A  A
In this issue:
» Sensex outperforms other indices over the decade in dollar terms
» Will China be the source of next crisis
» Are PSU banks value traps?
» Has SEBI got this one wrong?
» ...and more!

Investing in cyclical stocks is often compared to a roller coaster ride. Unlike the much talked about and favored defensive stocks like pharma and FMCG, the fortunes of cyclical businesses move in line with the fate of the economy and witness dramatic swings. As such, economic indicators like interest rates, consumer spending, inflation etc play a major role in deciding whether the business is in an upswing or trough. It's quite easy to distinguish cyclical stocks. These are the ones with flexible demand or low entry barriers. For example buying a car or setting up a cement factory. As such, in a poor economic environment, the cyclical businesses tend to fall out of favour because of low demand or increased supply or both.

With regards to investing, unlike the defensives that one can buy and hold for a long time, cyclical stocks can be risky and need investment in terms of time and research. Not just with regards to understanding the business but valuations and business cycles. So an obvious question would be why consider cyclical stocks at all for investing? Well, while high quality defensives are safer than cyclical, the valuation gap between the two could tempt one to consider the latter.

So before you consider making them a part of your portfolio, here is what you must know about cyclical stocks.

Within the cyclical space, one should look for companies most likely to benefit from an economic upturn. These will be the ones with low gearing levels and sufficient cash levels, companies with economies of scale and the ones that are relatively immune from changes in the regulatory framework.

A key point to investing in cyclical is avoiding the normal PE standards of valuation. In other words, a low PE cyclical stock doesn't imply it is cheap. This is because of the wide fluctuation in earnings of cyclical businesses. Infact, because of fluctuating earnings, a better valuation metric to consider is price to book value. Further, while PE itself doesn't make sense, one may consider Price to average earnings over an entire business cycle.

The best time to buy such stocks would be when the economy seems to be coming out of recession. But predicting business cycles in itself is a tough task. What makes it more complicated is that cyclical stocks tend to lead the business cycle by few months. However, some signs that investors can take a cue from are falling interest rates, increase in consumer spending etc. Also, investors should keep an eye on insider buying. Often, this is the time when the business has seen the trough and the management is more assured of a recovery and upside in the stock prices.

At last, we would emphasize that investing in cyclical is risky. In case you are planning to make them a part of your portfolio, make sure that the portfolio is well diversified and allocated across asset classes and sectors. That said, backed by strong research, patience and disciplined approach, cyclical can prove to be multibaggers.

Do you think this is a good time to invest in cyclical stocks? Let us know your comments or share your views in the Equitymaster Club.

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02:15  Chart of the day
In recent years, the Indian economy has been facing multiple challenges. The economic growth rate has been slowing down. Inflation has been quite high. Then there are the twin deficit concerns that show no signs of waning. The value of the Indian rupee has undergone significant depreciation against the US dollar. Lack of economic reforms and regulatory roadblocks have resulted in severe project delays and cost overruns. All these factors have taken a significant toll on Indian businesses. And that has reflected in the overall performance of stocks in recent years.

Now here is something interesting that every investor must take note of. Despite all the economic and political challenges, the BSE-Sensex - India's benchmark stock index - has outperformed all other emerging and developed economies over the last 10 years. And that too in US dollar terms! As per an article in the Economic Times, the BSE-Sensex has delivered an average return of 10.1% in dollar terms during the 10-year period since 2004.

We believe herein lies a big lesson for investors who have doubts about the merits of long term investing. In the short to medium term stocks tend to be quite volatile as people tend to put too much focus on the near term problems. But in the longer run, stocks do tend to deliver solid performance.

Sensex outperforms global indices in US$ terms

It is perhaps not news anymore that China is indeed finding the going tough for itself. There seems to be a near consensus that growth rates of the past are now a history for the dragon nation. As a result, the attention is now veered towards how big a hit will the world's second largest economy take and how is it going to impact the rest of the world. Fortunately, Societe Generale SA has done this work for us and it does not make for a good picture. The global financial firm has presented a worst case scenario of China growing by just 2%. And this will be enough to slash 1.5% from worldwide economic growth in the first year it reckons.

Why such a huge impact? Well, China's troubles will be transmitted through not just trade channels but the banking and financial channels as well and hence, the damage will be much worse. Needless to say that commodity exporting nations are going to be the worst hit. Another group of strategists over at Credit Suisse Group argue that China's growth need not collapse to 2% to affect global growth. Even a 5% growth is likely to send shockwaves around the world. Well, we are not sure the Chinese Government will allow that to happen however. Even a small deviation and they would promptly bring in more stimuli especially given the fact that they have ample headroom to do so. All in all, the can is going to be kicked further down the road with an even bigger bubble waiting to be popped in the future.

That LIC had to bail out the follow on offering of shares by the country's largest bank came as no surprise. For the insurer has in the past too bailed out equity offerings of PSUs that did not find takers. But the problem with State Bank of India (SBI) was much deeper. The bank, which has nearly 16% of the country's total credit in its books, is representative of the bad loans malaise in the sector. For a sector which thrives on growth in networth, bad loans eroding the same is a terminal problem. For Indian PSU banks, non performing assets are well over 5% of loan book. Even as they continue to lend to the troubled sectors like power and infrastructure and continue to restructure the loans, their asset quality is worsening. Moreover the risk that high NPAs pose to capital adequacy and return ratios of these banks has cautioned investors. Little wonder that despite high dividend yields and attractive valuations, most players in PSU banking space are being perceived as value traps!

SEBI introduced a slew of measures recently that were aimed to protect the interests of minority shareholders. For instance, it brought restrictions on related party transactions. More clarity was sought with respect to remuneration policies of top management. Also, it mandated that companies put a succession plan in place. All these measures shall improve transparency and corporate governance standards.

However, one step which it has taken has not gone down well with the investing community especially smaller fund houses. SEBI has increased the minimum net worth requirements of mutual funds to Rs 500 m from Rs 100 m. The regulator believes that this shall ensure only serious players will stay in the business. However, we beg to differ. Seriousness is not determined by net worth. It is determined by track record and ability to service the investors selflessly by understanding their needs. Size has got nothing to do with this. In fact, there are quite a few smaller mutual funds that are more efficient and have generated better returns than the larger ones. The move to increase net worth will eliminate smaller players who were committed to their clients. This shall be a disservice to small retail investors while the larger fund houses who have created their AUM through gross mis-selling will continue to prosper. We feel that if SEBI was indeed concerned about seriousness of smaller players it should have vouched for more disclosure and transparency from these firms. Eliminating small players under the garb of net worth will just ensure a larger plate for the bigger fund houses to feed on.

In the meanwhile Indian stock markets are trading firm. At the time of writing, the benchmark BSE Sensex was up by 141 points (0.7%). IT and consumer durables stocks were the biggest gainers. Most of the Asian stock markets were trading higher led by Hong Kong and China. The European markets opened on a positive note.

04:55  Today's investing mantra
"Go for a business that any idiot can run - because sooner or later, any idiot probably is going to run it.'"- Peter Lynch
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2 Responses to "Investing in cyclicals: Look before you leap!"


Feb 14, 2014

Now that SEBI has increased minimum networth for MF companies, what will be the future of those AMCs that fall below the requirement of 50Crores. Will they have to wind up? what will be impact on investors of these AMCs?


Ajit Kumar Maiti

Feb 14, 2014

Yes, I agree to start investing slowly in cyclicals, can use dips to build up, specially regarding India oriented cyclicals.

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