Constructing a Cyclical Portfolio

 | Jan 17, 2012 | 1:02 PM EST
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If there is one effective way to make a winning investment, it's to buy cyclical businesses at the bottom of the cycle and ride them as the cycle starts rising. Of course, this strategy would be easy if one could time cycles. But no one can with any degree of success. In addition, markets are forward-looking creatures. By the time signs start materializing that an industry is improving, shares have already gone up. 

Trying to time cyclicals is a fool's errand. But the wonderful thing about cyclicals is that after a long down cycle, the up cycle is usually lengthy enough so that timing is not such a big issue. You can miss the start, catch the initial stages of a cyclical recovery and experience a very attractive gain well before the cycle looks like it is heading for contraction.

United Rentals (URI) is the largest provider of industrial and nonresidential construction equipment in the U.S. and Canada. But URI doesn't sell its equipment, it rents it out. As a result, even though the collapse in construction activity still hurts the business, construction companies look at URI as a way to conserve cash. Instead of huge capital outlays to purchase a forklift or a boom lift, the company can merely rent it from URI. And if the construction sector continues to show signs of improvement, it's likely that those companies will still take a very gradual approach to growth and capital expenditure, suggesting an even stronger environment for URI. A regional construction company that is awarded a six-month job may find it very prudent to rent equipment for six months as opposed to buying and risk leaving the equipment idle after the job is finished.

URI recently decided to acquire its largest competitor, RSC Holings (RRR), and has really become the only reliable game in town. Regional competitors continue to struggle due to lack of financing. As a standalone, URI is expected to earn $2.48 a share in 2012, up from $1.69 in 2011. The integration of RSC should be relatively seamless and boost bottom-line growth quickly. Growth in the equipment rental market should remain robust over the next couple of years and any improvement in nonresidential construction activity will spur growth higher.

Speaking of cycles, construction aggregates have been scrapping a cyclical bottom for years. Sellers of materials like cement, sand, and concrete continue wait for the next growth cycle. One interesting name that stands out is Texas Industries (TXI), which produces such materials mainly in the western half of the U.S. Over the past six months, insiders have bought more than 20% of the company's outstanding shares. More intriguing, the company's short float is nearly 30%.

The aggregates industry is in the midst of a huge consolidation play as No. 2 Martin Marietta (MLM) is currently in the midst of a hostile attempt to acquire larger rival Vulcan Materials (VMC) for $4.7 billion in stock. Martin's desire to be the largest provider of one of society's most basic materials could indicate a cyclical industry turnaround in the next year or so. Texas Industries, with a market cap of $850 million and a low cost of production, could be in a very sweet spot going forward. The significant decrease in available shares along with the large short position adds an additional upside catalysts.

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