Dive Into Deep Cyclical Stocks

 | Feb 04, 2014 | 3:30 PM EST
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I had an extended discussion last night about the concept of margin of safety. In certain companies, it is easy to establish a margin of safety using price-to-book value and select financial measures like the F-score and Z-score to establish that a stock is safe and cheap. It is a little harder to establish a margin of safety in what I like to call deep cyclical stocks. These are stocks in industry groups like mining, steel, autos, homebuilding and other economically sensitive sectors. We have to adjust our thinking a little when evaluating these companies.

When these stocks are cheap on asset-value basis, at the trough of the economic or industry cycle, they tend to look horrible by many of the regular methods of evaluating a stock. The price-to-earnings ratio is going to be sky high as earnings are absent to a great degree. The company probably won't generate a high F-score as the outlook is bleak at the bottom for these companies.

First, we have to make sure this is really a cyclical industry and not a dying one. The stocks of buggy-whip makers probably looked cheap just before that industry disappeared off the face of the earth. Is there going to be a need for the products made by the industry going forward, and will pricing power be restored when the economy improves? The PC industry, for example, is not only cyclical but it has probably lost pricing power forever. We need to be certain that this industry is truly cyclical and that there will be an eventual upswing when conditions improve.

The first way to establish a margin of safety is to be a cheapskate when it comes to these stocks. When I identify an industry in a cyclical downturn that I believe will eventually recover, I only consider those that trade at 60% of book value or less. I have seen too many stocks I thought would improve drop from 80% to 50% of book value as conditions took longer to recover than I had anticipated. I have found that buying on a scale works best as I am probably early, so I can create an additional margin of safety by scaling in during declines subsequent to my initial purchase.

Now the fun questions. Has management navigated one of these industry declines in the past successfully? What were the earnings at the peak of the last upswing? Do they do a decent job of wringing some measure of profit and cash flow out of the business in the early stages of the decline? Can they keep the bills paid and the doors open until the sector recovers? Will they need to access the capital markets on unfavorable terms? Do they have an advantage over competitors in terms of size, cost or a specialized market niche?

The next questions are the more important ones when I evaluate a deep cyclical stock. Who else is buying? Are insiders buying shares in anticipation of a rebound in the industry or economy? Are the smart value players starting to buy the stock? Are there any activists taking positions and pushing to unlock shareholder value? And, of course, are the private-equity firms buying assets in the sector? To me their presence in the market is the single best indicator that a turn is in sight. I call this establishing a margin of safety by hanging around with really smart people.

Several stocks trading well below tangible book value might look ugly based on our traditional evaluation measures. Business looks horrid, for example, at Cliffs Natural Resources (CLF) right now, but the stock is cheap with the shares trading at 60% of tangible book value. Cliffs is one of the largest miners in the industry and has exposure to faster-growing Asian markets, which should eventually pay dividends for the company. It should be able to earn more than $5 per share easily when the economy turns around and excess capacity is worked off. An activist investor has taken a stake and is pushing for higher shareholder value and several private-equity firms have been raising money for mining investments. It may be a bumpy ride, but this stock should be many times higher than the current price some time in the next decade. The steep discount from asset value and the prospect of an eventual and inevitable recovery in the global economy creates a margin of safety that I find comfortable.

Investing in the deep cyclical stocks with a margin of safety and comfort takes a minor tweak to our process, but it can lead to huge gains as the economic cycle plays out over time.

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