Understanding cyclical stocks

MARKET INSIGHT

Though you cannot hold on permanently, cost-averaging can help.

Recently, a friend of mine asked, "How on Earth does one find stocks that have the potential to go triple (3x) or quadruple (4x) in this market?" There is both a difficult and an easy answer to this question.

Assuming that the investor is prepared to wait through a reasonable period of say, three years, a lot of stocks will triple and quadruple from current levels. One lot will consist of currently unknown names and be impossible to guess.

Every market cycle has its new leaders that zoom unexpectedly. It is a tough, high risk job to identify these stocks. The pay-off for finding even one such newbie winner is huge. Such new market-leaders are quite likely to return 6x or even 10x. For example, there were the multi-bagger IT stocks in 1999 and the real estate and broking stocks in 2006-7.

The other set of potential multi-baggers are much easier to identify. These are the cyclical businesses with sound fundamentals and battered stock market valuations. Look for the stocks that have lost the most ground and still hold the promise of remaining profitable in the long-term.

The entire auto and engineering-construction industry for instance, has seen massive sell-offs. It is well within the realms of possibility that the pricelines of Tata Motors, GMR Infrastructure, L&T, Bharat Forge, etc, will triple inside the next two or three years because these companies are unlikely to actually go out of business.

This sort of bounce back is also likely to happen with commodity businesses like the cement companies and the steel manufacturers. Or even with the shipyards and the shipping lines. Or, with engineering equipment manufacturers, such as Bhel, ABB and Suzlon.

These are not "sexy" businesses. But most of these companies have been around for a long time, and therefore, they have a proven ability to survive bad times. At the worst point of the cycle, they may even start registering losses.

However, once the business cycle turns around, it's also normal for these industries to see profits expanding by triple digits. At that stage, the price responds spectacularly to the turnaround. If you can time a cyclical correctly, it is possible to pick up a 3x or 4x price movement from trough to peak.

In practice, this usually means averaging down through the period when things look absolutely desperate. The other key factor is to sell as close to the peak as possible. Cyclicals are not great stocks to hold on a permanent basis.

The worst hit stocks in the market now appear to be the real estate businesses and the brokerages, which are both industries with cyclical characteristics. Those two sectors were among the market leaders in the last phase of the bull market, through 2006 and 2007. It is quite likely that these industries will never quite regain their lost glory.

These stocks were bid up to huge PE multiples and even though they will recover from current levels, they are likely to be more rationally priced in the next bull market. In both these industries, growth and profits will be stunted for a long time to come. Although some of these stocks have lost 90 per cent from their peaks, they could still have downsides and more to the point, they are unlikely to have major upsides.

Buying cyclicals deep into a downturn is a rational but risky method of operating. Unlike with FMCGs, pharma, or other perennials, a cyclical stock may not be able to maintain dividend in a downturn. So, there isn't a cushion for the investor to rest on. Your cash is committed; you will see capital losses and need to average down, until such time as the cycle turns around.

It helps if you have specific knowledge of the industry concerned. For example, an auto-industry worker would be more capable of timing the cycle in the auto and auto-ancillary industries. Ditto for a merchant seaman investing in shipping companies, shipyards and logistics businesses.

But specialised knowledge is not absolutely necessary. It is enough to know that a cyclical is in bad shape, that it is a market leader, and that it has enough resources to last out the downtrend. After that, it's a question of patience and deep pockets.