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Peter Lynch is one of the most respected names in the investing world. He is certainly my favorite investor. When I began investing, I really did not have any kind of deep financial background. Lynch’s simplistic, yet thorough view of how to navigate the stock market was incredibly refreshing.
Peter Lynch and His Investing Buckets with a Focus on Cyclicals
Peter Lynch’s strategies are legendary and have helped investors make better decisions with their money since he published his book One Up On Wall Street in 1989. You can visit our Video Shelf page on GEO here, which highlights Peter Lynch amongst other great investors.
Recall that in our last monthly open forum we highlighted 17 recession proof/resistant stocks (17:50) that we think could still grow during a recession, or at the very least partly avoid the negative effects of a recession. You can see these lists here (proof) and here (resistant) or by navigating from the Model Portfolio menu selection on GeoInvesting’s Pro Portal.
Now, in this article, I’ll discuss the basics of Peter Lynch’s strategies as it relates to investing in cyclical stocks. It’ll go over some basics on how to use the Lynch strategy to invest in cyclical stocks.
I thought this was an appropriate topic heading into 2023 with so many people talking about a looming recession. It serves as the perfect setup to understand the risks and opportunities associated with investing in cyclical stocks, along with when is the right time to buy or sell cyclical stocks.
The strategies that Lynch employed to achieve high returns (29.6%/yr for 13 years) are now referred to as the “Lynch Strategy.” The Lynch Strategy is based on the idea that it is possible to beat the market by investing in companies you are familiar with in your everyday life that are undervalued based on an investing process blueprint that covers growth potential and risk.
Now, many investors take his “buy what you know” approach out of context, something I address in this article. Lynch did extensive research on companies before investing in them. He also believed that it was important to have a diversified portfolio and invest in both growth and value stocks.
I originally covered Peter Lynch’s overall investment strategy, his stock-picking process, and how to apply his methods here.
Lynch’s process for defining his stock universe begins by putting stocks he was researching into 5 buckets:
- Slow growers (Touched upon in this article.)
- Fast Growers
- Asset Plays
Today, let’s briefly touch on the concept of cyclical stocks through Peter Lynch’s lens.
II. Understanding the Basics of Cyclical Stocks
The sales, earnings and thus share prices of cyclical stocks (cyclicals) tend to fluctuate with the overall economy and are associated with industries that are heavily affected by the economic cycle and consumer demand. (Example: stocks in the automotive, airline, hospitality, housing, building material and retail industries).
Cyclicals do well when the economy is strong and consumer demand is high, and conversely, can suffer when the economy is weak and consumer demand is low. This makes them an attractive investment class for those who are skilled at identifying economic trends or when it becomes fairly obvious that an economy is peaking or bottoming.
One great way to get a peak at the health of the economy is by reading conference call transcripts that management teams hold to discuss their quarterly financial results. It’s an invaluable tool that was not available to the everyday investor when I started investing over 30 years ago.
Some popular conference call transcript sources (free or premium) include:
- Seeking Alpha
- Alpha Street
- Motley Fool
- Sentieo (fee based)
- Conference Call Hosting companies like Issuer Direct Corporation (NYSE:ISDR)
- MS Microcaps (coming soon)
III. The Lynch Strategy for Investing in Cyclical Stocks
Timing is Key
Peter Lynch identified cyclicals as companies where sales and profits tend to rise and fall in somewhat predictable patterns based on the economic cycle.
Lynch believed that while some of these companies may be viewed as stalwarts (great companies), their share prices can drop dramatically during hard times. Thus, timing is crucial when investing in these firms, and Lynch says that investors must learn to detect the early signs that a business is starting to turn down.
He also believed that cyclical stocks can often be value traps when they look particularly cheap. This concept is a key characteristic of GARP investing. GARP stands for ‘Growth at a Reasonable Price’, and represents companies with good growth prospects that are undervalued or reasonably valued, as I explained within this Twitter thread on GARP stocks as follows:
13/25 GARP Essentially means that you’re looking for companies that are growing and not selling at pie in the sky valuations (no room for disappointment) or at extremely low valuations (since this may incorporate hidden risks).
— Maj Soueidan (@majgeoinvesting) October 20, 2022
Thus, investors may want to proceed with caution on cyclical stocks when they appear cheap, as explained in the next section.
Avoid Value Traps
According to Lynch, one of the primary characteristics of cyclical stocks is that their valuation ratios tend to indicate the opposite of what one would normally expect. With most other stocks, low valuation ratios correlate to being undervalued, while high valuation ratios mean the stock is overvalued. In the case of cyclical stocks, however, low ratios could correlate to the stock being expensive, while high ratios coincide with the stock being cheap. Why?
Remember, in the stock market what matters most from a valuation analysis perspective is future sales, earnings and cash flow, not trailing data points.
For example, a cyclical stock with a super low price to earnings multiple (P/E) based on trailing 12 months earnings could imply that the company may be reporting huge earnings at the top of a thriving economic cycle, but that profits will soon fall. Alternatively, a super high P/E could imply that the company is barely making any money at the bottom of a cycle, where prospects are about to turn positive. Peter Lynch is basically saying that you need look beyond the obvious and buy cyclical stocks at the bottoms when they look expensive and sell them at the tops of cycles when they look cheap, even though this thinking goes against traditionally intuitive value investing principles.
The evidence of this can be seen simply by looking at a company’s historical price to earnings ratio. If you look at the P/E ratio history of a cyclical stock compared to its stock price history, we can see that, in many instances, the share price is highest when the P/E ratio is low and lowest when the P/E ratio is high.
Lynch believed that it’s easy for investors who fail to understand the value traps that exist in cyclical stocks to be lulled into thinking that profiting from cyclical stocks is simple. When business is good and valuation ratios are low, investors falsely believe that this time, the stock will keep going up, even if history has shown that that is rarely the case. As he writes in his book One Up On Wall Street:
“Cyclicals are the most misunderstood of all the types of stocks. It is here that the unwary stock picker is most easily parted from his money, and in stocks that he considers safe. Because the major cyclicals are large and well-known companies, they are naturally lumped together with the trusty stalwarts.”
Cyclical stock investing is a perfect illustration of the greater fool theory, as those in-the-know sell or buy a cyclical stock to or from the uninformed.
Look At The Inventory
Lynch believed that company inventories are a strong indicator of when to buy and sell cyclicals. Inventories that are piling up are a warning flag, particularly if the company’s inventories are growing faster than its sales. As a result, Lynch says investors should sell if a cyclical’s inventories start to build up. On the other hand, when a company is at its low point, the first evidence of a turn-around could be when inventories start to be depleted.
Consider the Operating Profit Margin
Cyclicals with higher Operating Profit Margins (OPMs), also considered as the lowest-cost producers, have a much better chance of survival if business conditions deteriorate. Economic upswings can favor companies with low OPMs, leading to a disproportionate improvement in margin versus revenue growth. Therefore, investors who want to hold cyclical stocks through cycles would benefit by holding relatively high OPM companies for a long term and playing relatively low OPM companies for successful turnarounds/cycle turns.
On a parallel note, you might want to understand the operating leverage of a cyclical company. An example of high operating leverage is when a company’s operating costs do not change much with changes in sales. This is great when sales are rising, since more of the sales will fall to net income. However, when sales are falling, costs are not falling, leading to a rapid decrease in profits.
Know When To Sell
Lynch argued that a common investment mistake is that investors find it difficult to make money from their cyclicals because they hold on to them for too long. This is possibly because they choose to hold on to them, hoping the stocks recover from their dip. Or, they are waiting for a hefty dividend payout.
Lynch states that holding on to these stocks is a dangerous trap to fall into since he believes there is a high probability they’ll come back down. He writes
“Cyclicals are like blackjack: stay in the game too long and it’s bound to take back all your profit. If you hold from the bottom to the top and then back to the bottom again, you have not really made any money”
Here are some scenarios wherein you should sell your cyclicals, based on Lynch’s playbook. The Lynch playbook (src: @mjbaldbard) is a compilation of Peter Lynch’s investing strategies taken from his 2 books: One Up On Wall Street and Beating the Street.
- Sell towards the end of the cycle, although this can sometimes be tricky and difficult to determine.
- Sell when something has actually gone wrong within the company (example: rising costs, labor asks for increased wages, 100% utilization but spending on capacity expansion, etc.)
- Sell when there is strong competition for market share, leading to price cuts wherein the company cannot compete
- Sell when final product demand slows down while the inventory builds up.
Although we don’t love cyclical stocks, investing in them can be a way to diversify one’s portfolio and take advantage of market cycles to capture huge returns if you are ahead of the curve. Our bullish thesis we published on BXC in September 2016 (now up 871%) serves as a great case study of successfully investing in cyclical stocks.
Case Study of a Cyclical Stock – BXC
One particular example of a cyclical stock GeoInvesting once included in its model portfolios is Bluelinx Holdings Inc. (NYSE:BXC), a distributor of building and industrial products primarily used for housing, with lumber being one of its primary products.
As a cyclical stock, the company almost went bankrupt as a result of the 2008 Housing Crisis.
When we first found the stock around $8.80 in June 2016 and introduced the bullish idea to GeoInvesting Premium Members, it looked extremely expensive on a P/E ratio basis, since the company was losing or barely making money.
As a survival tactic, the company had been going through an extremely difficult multi-year restructuring to pay down debt and reignite growth. Some of these initiatives to save itself included selling off some of its real estate, shutting down unprofitable locations and retooling its sales and marketing strategy. When we found the stock, investors were getting impatient with the turnaround.
However, remember, especially with cyclical stocks, it’s about the future, not the past. And one stat stood out indicating that the future looked bright for the housing industry.
As the housing market slowly recovered from the 2008 crisis, in 2016, housing starts were still only at 1.2 M vs. 2.24M pre-2008. So, we felt good about the company’s growth prospects as long as it could get its balance sheet in order, which it did end up greatly improving.
We actually began to unwind our position in BXC during its first big run to ~$40.00 in March 2018. Today, the stock is trading at $71 and hit a 52-wk high of $100 in May 2022, but still well off its high of $160 in 2005.
Housing Date Source: macrotrends.net
Today, the stock is trading at a P/E of 2.07 and is not reacting as positively to impressive financial results as one would “logically” anticipate – exactly what Lynch would expect as recession fears are looming.
~ Maj Soueidan
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