Timing market cycles is notoriously difficult for investors. But the potential rewards are significant. Even large, well-established cyclical businesses can see huge share price swings over the course of a cycle – falling by 50% and then doubling (or more) is not unusual.
Right now, I think it’s fair to say that the real-world economy is still in the early stages of a recession – if indeed that’s what we’re going to get. But the stock market always looks forward. Share price action often precedes cyclical changes in profitability.
In my long-term portfolio, one of my priorities is to try and make sure I don’t inadvertently buy stocks at cyclical highs. Worse still, I don’t want to find myself on the downward leg of the cyclical rollercoaster.
With cyclical stocks, my aim is to try and buy them at valuations that are attractive on a through-the-cycle view.
Stockopedia’s screening system gives me access to a huge amount of historical financial data. Using some simple screens, I can easily slice and dice this data to test out different hypotheses and identify potential opportunities for further research.
This week I’m going to take a look at the valuations of some of the most cyclical and dirty sectors of the market – energy, mining, and industrials. These are businesses which play an essential role in keeping the world turning, but whose fortunes are often interlinked and subject to strong cyclical forces.
When building a stock screen, there’s often a temptation to use too many narrowly-defined criteria. In theory, this might produce the ultimate stock selection. However, real life rarely displays the neat patterns and perfect consistency that would be required for this to work.
One of the key ways I use screens is to narrow down my investable universe to a manageable size. With 2,000+ stocks on the London Stock Exchange, I can’t possibly research them all. But some carefully chosen screening criteria will reduce the number of stocks I need to consider to perhaps a few dozen.
I tend to keep my screening criteria fairly loose. I’ll then use the results of the screen as the basis for further targeted analysis.
To look for sectors displaying signs of cyclical value, I’ve built a screen using the following criteria (you can view the screen here):
- Sector: In this case, I’ll be looking at energy, basic materials and industrials. But the screen should work for other sectors, too.
- Market cap: I’ve specified a minimum of £250m, as I’m not interested in very small caps at this point. Larger, more mature companies tend to be a more reliable indicator of the cyclical trends I’m looking for, in my experience.
- StockRank: gt;60 – I want to find companies that are statistically more likely to have a favourable outlook.
- Dividend yield: I’ve specified a minimum yield of 1%. In my view, dividend payments are an important indicator of discipline, profitability, and cash generation.
- CAPE: the Cyclically-Adjusted Price to Earnings ratio. This traditional value metric averages a company’s profits over a number of years (usually 10) and then compares it to the current share price. Stockopedia’s screening system provides a choice of 3y, 6y and 10y CAPE. I’ve chosen them all for this screen.
- Rolling P/E: If a stock’s current P/E is higher than its CAPE, then I know that its current earnings are lower than its cyclical-average earnings. This might suggest an opportunity. Conversely, if the current P/E is much lower than the CAPE, then earnings may be at a cyclical high.
Do commodity producers offer cyclical value?
Let’s start with two stocks du jour. Big Oil firms are reporting bumper profits and seem to be poised for another strong year. However, the market is stubbornly refusing to accord a high valuation to these stocks. Why might this be?
My screen shows that both Shell and BP are currently trading with 10y CAPE ratios that are roughly twice their current P/E ratios:
It’s a similar story with the FTSE 100’s big miners (and cement/aggregates group CRH):
Comment: Broadly speaking, all of these companies are trading on a rolling P/E that’s twice their CAPE 10y. That suggests current profits are twice as high as the cyclical average.
In my view, these numbers suggest that profits in both the big cap energy and mining sectors are close to cyclical highs.
Despite this, I’m not predicting an imminent crash for these sectors. Given the prevailing macro and political factors, I think it’s quite possible that the good times will keep rolling for a while yet.
However, history suggests a downcycle will follow at some point. For an investor like me, who might want to build a long-term position in such companies, that will be the time to buy.
Industrials: emerging value
One sector of the market where I feel that some cyclical value may be starting to appear is the industrial sector. In the UK market, these are mostly small and mid-cap firms. There aren’t a huge number to choose from, but I think some of these businesses have attractive qualities.
For example, most of the companies on my radar at the moment benefit from a mix of valuable intangible assets, including intellectual property, durable brands, and long-established customer relationships.
(In fairness, I should point out that the industrial sector is officially classified as sensitive, not cyclical. What sensitive means in practice is that demand for their products or services may vary through the business cycle. However, they’re unlikely to experience the extreme swings in price and volume as commodity producers such as miners.)
My cyclical value screen suggests that some UK industrial stocks are now trading on a forward P/E that’s higher than their CAPE 10y rating. Here’s a selection of results from my screen, sorted by StockRank:
I’ve highlighted some companies where I think the valuation is starting to look potentially attractive. These companies aren’t necessarily bargains, but when paired with a high StockRank I think they may be worthy of further investigation.
I’ve not covered Bodycote to date, but this heat treatment specialist has come onto my radar in several screens recently. I may look into this business in more depth in the coming weeks.
Disclosure: Roland owns shares of Shell and Redde Northgate.
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