Challenges and opportunities of investing in cyclical business
: While value based asset manager RE:CM believes pockets of affordability have started to appear in certain cyclical stocks, particularly in the resources sector, it cautions investors looking to take advantage of these opportunities to ensure they unders
According to RE:CM analyst Razeen Dinath, a cyclical business is a company where the earnings of the business are primarily determined by macroeconomic gyrations, with management having limited impact on profitability. “When the economy is on the up, the business does fantastically well, but when the economic cycle turns, the business suffers. Examples of cyclical businesses in South Africa include mining businesses such as Kumba Iron Ore and construction businesses such as Murray and Roberts.”
He says that although a cyclical business can be a good investment, investors need to be sure that they are investing in the trough of the cycle when others are fearful. “This is not an argument for investing based on forecasting the macroeconomic cycle. Without the assistance of a crystal ball, no one is going to be able to call the exact trough or peak of a cycle with any sort of accuracy or consistency. It is simply highlighting the fact that a cycle turns and that favourable operating environments precede harsh operating environments, which evolve into favourable operating environments again.”
Dinath says that during good times, favourable trading conditions for cyclical businesses arise when the demand for a business’s products or services are at high levels, and this is sometimes preceded by a temporary decrease in competition or a lack of competing supply. “The mismatch between supply and demand allows the incumbent business to generate super profits and earn a return on capital well in excess of the cost of that capital.
“The problem is that these excessive returns attract competition into the market that ultimately brings additional supply. This increased competition erodes the incumbent’s profits until returns only cover the cost of capital. If market participants are greedy and too many competitors enter the market with dreams of super profits, supply can dwarf demand and market players revert to selling their products and services at profit margins that do not even cover the cost of capital. Some participants therefore cannot survive these conditions and leave the market. This continues until too many participants leave the market and there is insufficient supply to meet the demand. And so the cycle begins again.”
Dinath says that one of the pitfalls in valuing a cyclical business occurs when an investor ignores the fact that the business is a cyclical business. “Investors will be led to either over- or under-value a business when focussing on the more recent past and accepting the current situation as the ‘new status quo’. This in turns leads to a misallocation of capital and poor returns.”
He says that this error can be avoided by normalising earnings through the cycle. “This is, of course, easier said than done. Normalising earnings is more than simply determining a normal profit margin and applying this margin to sales. The sales figure in the last financial period would also be a function of where the business finds itself in the cycle. As such, normalising earnings actually implies normalising the entire income statement starting with the revenue line.
“To determine the value of future earnings streams, investors tend to ignore the balance sheet. In spite of the balance sheet being perceived as more stable than the income statement, the balance sheet items also move in line with the economic cycle in a cyclical business. The level of working capital required will change as the business cycle changes.”
Dinath says that even the level of capital investment is affected by the position of the cycle. “Just as investors are more likely to buy stocks when they are surrounded by good news, management are more likely to add capacity when the going is good than when times are tough. Moreover, debt levels can rise as management uses debt to fund this additional capacity.”
He explains that investors do not need to call the exact trough in order to take advantage of these offerings. “The time to prepare for and to be aware of investment opportunities is when the cycle is high and investor sentiment towards a business is positive. The best preparation is the realisation that cycles do turn. RE:CM has been patient and waited for those times of negativity and fear that invariably come with business cycles to see what bargains the market presents,” concludes Dinath.
