Investment strategy for cyclicals

Spread investment across companies so that you are not stuck with entity-specific issues

One way to lose money is to bet on favourites at horse races. The odds available are low and the favourites don't win often enough to yield post-tax profits. For example, if a heavily backed horse is available at odds of 5:9 (common enough), it must win three times out of four to offer a post-tax profit.

However, it is possible to play favourites in the stock market and earn decent returns with low risks. A long-term portfolio of blue-chips, or passive systematic investments in a stock index, will beat inflation. But getting an extraordinarily high return, more than the favourites offer, requires higher risks.

One type of dream investment, if you can find it, is a new business, which becomes a market leader and multi-bagger. It is even better to identify a high-growth new business sector, such as information technology or biotech. Such a sector can yield many multi-baggers. This sort of investment carries huge risks and new sectors don't open up every year. To get in on the ground floor, the investor must bet, on new sectors and on companies with not much in the way of track records. Venture capitalists and private equity players use versions of this strategy. They accept heavy losses every so often and emerge ahead only if they generate really excellent returns when they win.

Another method of trying to score extraordinary returns is to pick companies in distress, looking for turnarounds. Here, the investor has a track record to examine. He must identify the underlying causes of trouble, and assess the company to see if it can be a genuine turnaround. Soft factors like quality of management, brand recall, etc, will often be important.

There are obviously major risks. But turnarounds can give terrific returns, often becoming multi-baggers. Even in extreme cases like frauds, a change in management can lead to massive payoffs for investors willing to stomach risks. Look at Satyam. Investors who bought into the IT major during the dark days of 2008 have received superb returns.

A third method of high risk, high return investing is picking beaten-down cyclical businesses. The distinction between 'corporates in trouble', and beaten-down cyclicals is important, though there are often overlaps and the balance sheets could look similar.

A corporate entity in trouble can be defined as a business suffering from company-specific problems (in addition to whatever cyclical issues there may be). In contrast, a well-run business in a cyclical sector could be struggling at periods when the entire sector is in bad shape.

Most segments have some cyclical characteristics. Automobiles, paper, commodities in general, electronics, shipping, construction, etc, are all highly cyclical. Business is very good at the peak and bad at the trough. Share prices often multiply by factors of four or five between the bottom and the top of the cycle.

The management in any cyclical business could be excellent. But the nature of the business will still mean periods of industry-wide slumps and also boom periods. The risk in investing in cyclicals is less than the risk in investing in brand-new businesses, or those with company-specific problems. There are track records for cyclicals and, if a given business has survived the previous trough, it will probably survive the next one as well.

Share price and earnings will always be slightly out of sync. One paradox is that cyclical valuations can run high at the bottom of the cycle and low near the top. This is because earnings may shrink, or grow, quicker than the price falls, or rises. Timing is important in the broad sense. The investor needs to have a sense of where the business cycle is trending.

Multiple cyclical businesses are still seeing dismal performances at the moment. Cement for example, is in trouble. So are shipping, mining, ports, metal producers and tractors. If you can create a portfolio of such businesses eventually at the bottom of a cycle and wait it out, excellent returns are very likely.

Some points are worth considering. When buying into a cyclical business, it might make sense to spread investments across several companies. If one does well, most will and this shotgun method reduces the chances of returns being hit by company-specific issues.

Also, in principle, profits can be booked in cyclicals, preferably as close to the top of the cycle as possible. The stock can be picked up again when it heads down. This is another point where cyclicals differ from turnarounds. You might want to hold a non-cyclical turnaround indefinitely.