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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):
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 half their CAPE 10y. That suggests current profits are twice as high as the cyclical average. (Corrected 2/11/22)
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.
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.
For some initial background reading, I covered Morgan Advanced Materials here in Dec ‘21 and Redde Northgate here more recently. Jack made some interesting comments on Ricardo in a February SCVR.
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.
About Roland Head
I'm an investment writer and analyst, with a particular focus on systematic investing and dividends. I look for quality stocks with above-average returns, strong cash generation, and attractive valuations - always with dividends.
In my earlier life, I worked as an systems engineer in telecoms and IT. The quantitative, rules-based approach required for this kind of work suits me and has certainly influenced my investing style. I also learned a lot from seeing the tech bubble deflate in 2000/1, when I was working for a large and now defunct telecoms group.
Disclaimer - This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
Hi Roland,
Can I check this.......
The P/E ratio is the share price divided by the Earnings per share
The CAPE is the share price divided by the average Earnings per share over n years (adjusted for inflation)
So if the P/E for a company is 5 and the CAPE is 10 surely that means that the current share price is cheap relative to the 10y average?
....and that means you should in fact be considering buying these miners now?
Thanks for asking that question robino ... I was too scared I was missing something obvious to ask it myself. The clear conclusion for me is that miners look underpriced c.f. the norm. What is it that I have failed to understand?
Hi,
To understand this fully just play with a couple of random numbers. Say a company has a price of 10 and a earnings of 1 in a recession.
Therefore P/E = 10.
Now at the top of the cycle the earnings might be 5 (assuming the price is the same):
P/E = 10/5
P/E = 2
Hence cyclical companies can look "cheap" when they are expensive and "expensive" when in fact they are cheap.
Your example would be more realistic if you proposed a top of the cycle SP of 30, giving an “expensive” P/E of 6x - despite still looking cheaper on a multiple of earnings. This would broadly approximate the relative market values across the cycle and graphically illustrate the value curve.
Hi Robino
I think that the point here is that we are talking about cyclical shares. The reason that the PE is half the CAPE is that the profits are expected to fall.
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.
I think this is the wrong way round at least looking at the screen data. The first sentence of the above statement should replace twice with half to make sense. Unless I am missing something!
Yep ... it's a very confusing piece. It is the article that is 'missing something'.
Hi ACounsell,
It should of course have read that the rolling P/E was half the CAPE 10y.
Thanks for highlighting this error - I have now corrected the article.
Regards,
Roland
Hi robino,
Thanks for asking the question. Perhaps I should have been a clearer in the article.
For any given share price, a lower P/E means higher earnings.
This means that if the P/E is 5 but the CAPE 10y is 10, then current earnings are twice as high as the 10-year average.
For example:
Share price: $5
Current earnings of $1 per share
10-year average earnings of $0.50 per share
Current P/E = 5/1 = 5
CAPE 10y = 5/0.5 = 10
When the current P/E is lower than the CAPE 10y, this tells us that earnings are currently higher than the cyclical average earnings.
I hope this helps,
Roland
Indeed - It's best not to buy cyclics when recent or forward P/E is low because in cyclicals this indicates that earnings are close to cyclical highs. Instead it's better to buy cyclicals when earnings are low compared with the through-cycle average (or based on a low P/NTAV), also with reference to the through-cycle share price and only those companies whose CAPE valuations are reasonable. Thanks Roland for a much needed article.
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Thanks, Roland, lots to take in. Always good to learn new ways to fly the Stocko jet plane, and be reminded of fundamentals too.