Look for cheap stocks in cyclicals

In perennial sectors, it may be better to focus on the best business, even if that stock is more expensive

Let’s use an analogy to illustrate the behavioural quirks of stock-picking.  Say, you need a new cell phone. There are certain features which are must-have, and other features that you consider useful or attractive. After you’ve narrowed down choices, price is a determining factor: given two gadgets with similar performance, you’ll pick the cheaper.

When it comes to picking a stock, there are some similarities and a couple of key differences in selection process. You’ll certainly look for stocks, with essential features such as good growth rates, sustainability, honest management, etc. You may widen your search rather than narrowing it because many stock-picks start “bottom-up”. The investor notices a company with a strong business model. Upon researching the sector, he discovers other companies with related strengths and weaknesses. That’s one difference.

A bigger difference is the attitude to price. Investors who research several companies with similar performances often pick the most expensive! This holds true on a broader scale as well. Investors choose the more expensive sectors, and more expensive markets, when investing across markets.

One reason for this is the rational belief that the market knows more than you. The premium for one company may be based on variables that you don’t know, or have not considered. A second reason is the statistical basis for momentum investing: stock that have better historical performance tend to perform better in the future because price trends (and presumably, the factors underlying trends) are persistent.

A third reason is that investors draw comfort from strong historical price performance when buying a stock.  This is logical if you may want to cash out positions quickly. However, if you really believe in a business and you’re prepared to hold it for the long-term, you should probably be looking for the lowest price you can pay for it.

One area where it doesn’t much make sense to buy stocks trading at a premium is in certain cyclical sectors. Let’s say, you’re interested in industrial metal manufacturers in steel, copper, aluminium, zinc, etc. This is a commodity sector.

One business may be better managed than the others and that business will get a higher premium from the market. However, if the commodity cycle is down, all companies in the sector will be punished and when the cycle is up, every company will make profits. Moreover, purely from a price perspective, the most beaten-down, lowest-priced companies will tend to give the highest returns when the cycle does uptrend. This is well-known.

This pattern is true for most cyclical sectors such as aviation, automobiles, and even IT. There may be a sector leader but prices will move in tandem as the cycle shifts. For example, if we look at the current players in the IT sector, there are obvious differences in valuations. However, prices are also highly correlated. When TCS or Infosys is trending up, so are the smaller companies in similar spaces. When an Infosys or TCS goes up, the chances are that the share prices of other IT companies will also rise.

This seems true for automobiles and auto ancillaries too. The two-wheeler segment moves in tandem, so does the tractor segment, and passenger cars, commercial vehicles and ancillaries as well. Sure, there will be leaders but as the old saying goes, “A rising tide lifts all boats”.  This is also true for petro stocks. When the price of crude and gas is down, every refiner makes money and vice-versa, every refiner faces margin squeeze when crude is up.  

This correlation in price performance is not true for non-cyclicals. In FMCG and pharmaceuticals, for example, the market leader could receive a premium and there may be long periods when prices are not correlated. Only one stock maybe making gains while the others languish. It also doesn’t hold for certain cyclical sectors. For example, there can be a clear difference between price-performance of one heavy engineering outfit, or a leading construction firm, and the other players.  

In many cyclical sectors therefore, there is a strong case for looking at the stocks that are trading at low valuations. If the cycle does uptrend, the cheap stocks will give better returns. But in perennial sectors, it seems it may be better to focus on the best business, even if that stock is more expensive than its peers.