How to invest in cyclical stocks

With stock prices trending downward across the board, value investors are looking for bargains among high-quality stocks that have solid long-term prospects. When researching for potential value opportunities at a time like now, when the stock market is on a downward trend but commodity prices remain high due to shortages, many value screens become full of cyclical stocks due to their low valuation ratios.

But according to Peter Lynch, one of the most famous investors of all time who averaged an annual return of 29.2% for the Magellan Fund between 1977 and 1990, cyclical stocks are typically value traps when they look particularly cheap. Therefore, investors may want to proceed with caution on these stocks for now, given Lynch’s observations on the rules for cyclical stocks.

Fraudulent valuation ratios

One of the primary rules for cyclical stocks according to Lynch is that their valuation ratios tend to indicate the opposite of what one would normally expect. With most other stocks, low valuation ratios correlate with being undervalued, while high valuation ratios mean the stock is overvalued. However, with cyclical stocks, low ratios usually correlate to the stock being expensive, while high ratios usually coincide with it being cheap.

We don’t have to look very hard to find evidence to support this observation. If we look at the history of the price-earnings ratio of almost any cyclical stock compared to its stock price history, we can see that the stock price is typically highest when the price-earnings ratio is low and lowest when the price-earnings ratio is high (or when it cannot be calculated due to the company losing money).

Once an investor has identified this trend, they may be lulled into thinking that it is easy to profit from cyclical stocks, but the valuation trends of these stocks are more misleading than they appear. When business is good and valuation ratios are low, greed tends to overtake logic, and many investors begin to believe that this time will be different; that this time the stock can keep going up forever, even though history has shown that this is rarely the case. As Lynch writes in

One Up on Wall Street:

Cyclical stocks are the most misunderstood of all types of stocks. This is where the unwary stock picker is most easily separated from his money, and in stocks he considers safe. Since the large cyclical companies are large and well-known companies, they are naturally lumped together with the reliable stalwarts.

When the good times no longer roll

So why are cyclical stocks different from most other stocks? Why do their valuation ratios have a long and storied history of lulling investors into a false sense of security? The reason for this is that the profits of cyclical stocks swing wildly up or down based on the overall economy and macro demand for the particular commodities they sell.

A cyclical is a company whose sales and profits rise and fall in a regular if not entirely predictable way, Lynch wrote. In a growth industry, the business continues to expand, but in a cyclical industry it expands and contracts, then expands and contracts again.

When times are good and a cyclical company is experiencing a bumper year, its earnings will skyrocket, resulting in low valuation ratios as the market is reluctant to revalue a stock that investors know will eventually decline. In a bad year, profits will take such a sharp dive that even a sale will leave the company with high valuation ratios.

Imprudent stockpickers can easily part with their money when it comes to cyclical stocks because they see good performance and mistakenly believe the increases can last forever.

However, the truth is that one day the good times will no longer roll, and making profits from cyclical stocks is mostly dependent on the market having the right timing to seal gains before things turn sour. Lynch notes that it’s in cyclical stocks more than any other type of investment that you really need some sort of advantage to be successful, like working in the industry you’re investing in.

Don’t stay in the game too long

Apart from choosing the wrong times to buy and sell cyclical stocks, another reason why many investors find it difficult to make money with these stocks is because they end up holding on to them for too long. Perhaps they choose to hold the stock longer than they originally intended because it went down and they are hoping for a recovery. They may also stay for a hefty dividend.

Since cyclical stocks will always fall again, holding them for the long term is a dangerous trap. As Lynch wrote, cyclical stocks are like blackjack: stay in the game too long and it’s bound to take back all your profits. If you hold from the bottom to the top and then back to the bottom again, you haven’t really made any money (except maybe dividends).

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