Contributed By: Udai Cheema
When it comes to investing in cyclicals, a handful of names come to mind for having successfully practised the art and one such name is Jiten Parmar. So, when an opportunity to hear him speak on cyclical investing presented itself on 14th December 2019 at Holiday Inn, New Delhi, you bet I was there. The conferences held by CFA Society India are slowly becoming the industry benchmark for their rich content and this one was no different.
With this post, the goal is to summarise this insightful presentation made by Jiten and deliver the essence of his talk in the most effective way.
Here are some of the highlights from his talk;
- Whatever has been learnt, has been learnt through trying, making mistakes, reflecting upon them and trying not to repeat them. This journey over the years has been intellectually enriching and financially fruitful.
- Investing is an amalgamation of multiple disciplines such as psychology, history, sociology, politics, science and not just finance. Understanding your behaviour and the market’s (other participants) behaviour is crucial for success in investing. Politics has a strong bearing on our markets especially in highly regulated sectors like sugar etc. so if we don’t understand the policies of the government in these sectors it’s difficult to invest in them. For example, some recent policy changes regarding ethanol production by companies in the sugar sector has made the industry less cyclical than what it empirically has been. With housing for all as one of the primary agenda for the current government and subsequent implementation of RERA, it was clear back in 2015 itself that the real estate prices will stay in check for the foreseeable future. This way one needs to read into the Government’s actions and try to think of the 2nd and 3rd order effects that they might have for a sector in the short/long term.
- Different people have different temperaments, so it’s critical to ‘Know yourself‘. Some are good traders, some are good investors, some don’t fancy cyclical investing that much whereas some are all about cyclicals, so it’s quite individualistic and one has to find an answer to that within. Cyclical investing can be quite a lonely place at times because usually, no-one is interested in your stock when you discover it and there is no set timeline as to when the winds will start blowing in your favour, if at all they do. These can be testing times and not everybody can handle it, just like the stresses associated with day trading are not everyone’s cup of tea. It’s your conviction and mental strength that comes to your rescue in times like these.
- There is much more cyclicality in the world than we think. Cyclicality is all around us and not just restricted to a few commodity-based sectors. Markets are cyclical, the economy is cyclical, returns are cyclical. Infact, most things in life are cyclical, it’s just that the degrees vary.
- Cyclicality can be divided into three categories based on their degree;
- Deep Cyclicality – Commodity businesses such as steel, cement, etc. are good examples.
- Moderate Cyclicality – Eg. cars, financial services.
- Low Cyclicality – Eg. FMCG sector.
- One needs to look at two cycles, the business cycle and the other is the market cycle. So even if the business isn’t cyclical, it will be affected by the market cyclicality. So understanding these two cycles can make a lot of difference in the returns one ends up making in the markets. He shared a great quote by Howard Marks;
Rule No. 1 : Most things will prove to be cyclical
Rule No. 2 : Some of the greatest opportunities for gain and loss come when other people forget Rule One.
- Within sectors and stocks, one has to comprehend ‘business cycle’ as well as ‘market cycle’ and they might not coincide. So investors need to make adjustments accordingly. ‘Best price’ may come before ‘best results’ and ‘worst price’ may come before ‘worst results’. The exit is absolutely crucial in cyclicals, better early than late as things can change very quickly depending on the demand and supply situation which makes any sort of earnings predictions extremely difficult.
- It is true that one can’t time the market but one doesn’t have to get the timing exactly right. Even if the investor can get the direction of the cycle right and be ‘approximately’ right, it’s good enough. We don’t have to get in at the ‘bottom’, nor do we have to get out at the ‘top’. Exiting a bit early and leaving something on the table is a good strategy to follow in case of cyclicals.
- Gave the example of a leading FMCG company that increased revenues from 10000cr to 19000cr between 2001 to 2011. Profits from 1600cr went to 2300cr but the stock gave zero returns during the period but the same company from 2011-2019 grew its revenues to 37000cr and profits to 6000cr and during this period the stock went up by 900%. The company is currently operating at all-time high EBITDA margins and they can’t keep rising forever. Similarly, a leading IT company has multiplied profits 37 times since 2000, but the stock price is yet to see the price once achieved in the year 2000. So, getting in at the wrong time can be dangerous for any type of company, be it quality, low cyclical and definitely for the companies in a deeply cyclical sector.
- Refutes the argument of ‘quality at any price’. A company growing revenues at 10% YoY should not be trading at multiples of 80-90.
- A big question that investors need to ask themselves while investing in cyclical is,
What do we expect/want from the investment?
Most of the time people think that it’s going to be a joyful ride to wealth, not realizing that they are also prone to speed bumps and accidents. More so when we try to piggyback on someone else’s research and conviction or try to be too adventures and start performing dangerous stunts with our money. It’s better to take help than to lose money.
- There is a difference between perception and reality when it comes to success. Most people think that it’s a straight road to glory but in reality, it’s a much more convoluted path with multiple traps that can lead to failure. Every investor no matter how successful suffers from self-doubt at times and this is where the mental strength of the investor gets tested.
- Shared an original quote with the audience to explain a critical aspect of cyclical/commodity investing;
Cyclical/Commodity plays are like going to a pub. Enter during happy hours and leave at midnight when the party is in full swing. Even if you stay late, be near the door, or you might end up paying the bill for others too.
On the contrary, people enter during the rush hours and try to stay until the end. That’s where the chances of getting trapped are the highest. Instead, if you leave something on the table still there will be handsome returns for you in such cyclical plays.
- One needs to keep in mind that cyclical businesses can give phenomenal returns in the years of the business upcycle but they can give equally phenomenal draw-downs when the business cycle takes a downturn. So, getting the business cycle right is crucial for success. As a general rule of cyclical investing, the sector leaders give less upside in upcycle and less downside in downcycle.
- First of all the investor needs to understand the commodity price cycle to identify the peaks and troughs which are underlying for the booms and busts in the stock price of these commodity-based companies.
- Investing in cyclicals requires the investor to be a contrarian and follow the counter-intuitive/inverted approach. That’s because listed below are a few things that you are required to do while investing in a deep cyclical/commodity-based business;
- Buy when ratios are bad – EBITDA margins, ROE’s are down. The company might be in a loss.
- Sell when these show sharp uptick and the company becomes highly profitable.
- Buy, let’s say when PE is 60 (or negative) and sell when it is 6.
- Buy when the sector is completely neglected and sell when it is hot.
- Buy when no one is covering the stock and sell when many buy reports come.
So, a contrarian approach is required and you are basically betting on reversion to the mean. Simply put, one needs to buy when the stock is down n out and the sector is written off and sell when it’s the talk of the town with increased coverage.
- The evaluation parameters include;
- Triggers show up. Identify the sector/commodity behind the triggers.
- Study the past cycles.
- Study production data, supply/demand.
- Check for capacity utilization.
- Check for Capex (when many companies announce, great signal to relook/exit).
- Check the margins.
- Check Price to Book (current, historical during upcycle and downcycles).
- Check replacement costs. P/B and replacement cost are good parameters in the case of deep cyclicals.
- Check for insider buying/selling.
- Check if the company has cash/manageable debt.
- Don’t look at PE ratio.
- Start initial buying at the highest pessimism levels.
- As cycle starts turning, add.
- Some examples of triggers include;
- Sugar: 2 years of monsoon failure in India and failed Brazil crop in 2015.
- Paper: Largest producer BILT plants closing down.
- Fertilizers: A good monsoon after 2 failed years.
- Polyfilms: Increasing delta between RM and finished product.
- Chemicals: China measures for pollution control and closing of many units, ADD (anti-dumping duty)
- Metals/mining: Chinese plants started closing down due to pollution. For Steel – MSP, Infra focus.
- Cement: Government focus on infra, supply not coming as per estimated demand leading to higher capacity utilization.
- It so happens that in a prolonged downturn, a lot of companies tend to perish due to unsustainable losses especially the ones that don’t possess adequate balance sheet strength to survive. Hence, before making an investment in a deeply cyclical business, the investor must make sure that the company has the financial strength to see through the adversity. If it fails to hold up in an extreme downturn then you run the risk of permanent loss of capital. Another way to mitigate this risk is to follow a basket approach i.e buy a couple of stocks from the same sector to form a basket of stocks, in case one of the companies doesn’t survive, the portfolio will be less affected compared to a single stock portfolio.
- Exit strategies;
- Try to get out before the best earnings. Peak prices come before peak earnings.
- Always understand that there is “extra-ordinary” earnings in upcycle. Don’t commit the folly of assuming these as normalized earnings and look at it with a PE lens.
- One can employ a strategy like getting in at 0.2-0.3 of P/B or replacement cost and getting out at 1-1.2 of these.
- Try to estimate normal EBITDA margins by averaging them over downcycles and upcycles. Accordingly, calibrate your entry and exit strategies.
- Never repent if price still goes up after you sell, as long as you have good returns.
- Rules to follow;
- Always make positional plays. These are not long term buy and hold kind of stocks and the maximum holding period is usually not more than 2-3 years.
- Patience is required. Be ready to hold until the story plays out.
- Adhere to strict portfolio allocation. Avoid going beyond 25% of the portfolio in a single deep cyclical sector. One can cut down the allocation to bring it down to 25% if it exceeds, that way you also get to take some of the profits home.
- Do not change the narrative, just to hold onto the sector/stock. For example, the change in the narrative of sugar-based companies to now ethanol-based businesses might have reduced the cyclicality in the sector but it doesn’t take it away. The base product that is sugar is still an Agro-commodity which is highly regulated and policy-driven. Another such change of narratives played out in graphite electrode stocks, people simply converted what was a whiplash cycle into a structural story and it did not end well for those who entered at the top or did not sell in time. Generally, the cycles that rise too fast don’t last very long.
You entered them as a commodity play, so treat them as a commodity play & exit them as a commodity play. Don’t change the narrative!
- Be prepared for failures. Cut when you realize it. Always keep your initial buy small so that if there has been a mistake and you have to cut your losses, the portfolio doesn’t get materially affect. Instead, try to build up the positions as the conviction grows and triggers start to appear.
- Some observations;
- There are different strategies in investing and each has its merit. Choose the one that works for you. We don’t need to copy anybody, rather we should try to understand ourselves and see what suits our temperament.
- Successful investor trait – remove bias, rigidity. Try your hand at various styles of investing and see if it’s for you or not. Be and stay a learner.
- When good times come, make them count. One can use a trailing ”profit protection” i.e once you have realized that it’s time to exit from a stock (be it a cyclical or an overvalued quality company) but you know that it’s in fancy and you wish to ride the maximum upside, put a mental trailing stop-loss in place. For example, once your desired exit price is reached, simply put a 10-15% trailing stop-loss and exit at once if it hits otherwise keep riding the trend.
- Many investors keep watching the index, watch your stocks instead.
- Good stock at a bad price may underperform bad stock at a good price.
- Investing is more of an art than science.
- Temperament is the most important quality of a good investor.
- Some case studies with financials taken from screener.in;
1. A Graphite electrode company in which the OPM jumped from 16% in 2016 to 71% in 2019 and during the same period, net profit went from 4cr to 3026cr. The PE was 150 at the price of 150 Rs which came down to 5 when the price hit 4500. The best time to invest was when the PE was 150 rather than when it became 5. The best results for the company came a year later in 2019 but the stock price had already corrected significantly by then. So, the price peaked way before the best results. That’s why one needs to think counter-intuitively when it comes to cyclical investing.
2. A Paper company that had operating profits of -39cr in 2012 and OPM of -17% which transformed into an operating profit of 71cr and OPM of 22% in the year 2017. During the same period, the stock price went up from Rs 10 to 280. As it’s a cyclical stock, the operational metrics, as well as the stock prices, have cooled down ever since with the stock trading at Rs 75 in the more recent times.
3. A Polyfilm company delivered a net profit of 1056cr in 2011 from a net profit of 94cr the previous year, subsequently in March 2014 the company ended the year with a loss of 7cr. That’s how the cyclical whipsaws tend to work. The stock price went from 90Rs to 475 Rs within a year’s time. The margins went all the way down to 3% in 2014 from the peak margins of 36% in 2011.
4. A highly profitable metal mining company consistently had OPM above 40% YoY but due to certain factors the year 2016 saw the OPM drop to 11%. Considering the average OPMs for the company were way higher in the past, this appeared to be an anomaly of sorts and anomaly it was as the margins recovered back to >40% in the next two years. The stock price went from Rs 90 in 2016 to Rs 265 in 2018. Considering it’s a PSU, the risk-adjusted return from the investment was quite good considering the time frame.
- Some helpful sources of information;
With this post, my goal was to summarise this insightful presentation made by Jiten and deliver the essence of his talk in the most effective way. He has been kind enough to share the slides of his PowerPoint presentation from the event. Link to the slides can be found [Here]
The article was originally published at : https://www.investorsingh.com/all-about-cycles-and-cyclicals-with-jiten-parmar-a-cfa-society-india-event/