Jelly Roll Capital Equity Research

Market Analysis, Education, and Wall Street-Quality Stock Reports

Buying the Bottom of the Cycle

One of the drawbacks of being a publicly traded company is the constant need to meet Wall Street analysts’ growth targets. Companies are always expected to make strategic moves that grow profits and create shareholder value. Strong, consistent growth normally results in an increasing stock price — but the inverse is true: companies that struggle to consistently grow profits typically have a volatile stock prone to significant declines. Some businesses have less control over their earnings growth than others; specifically, many industries are heavily dependent on a strong economy. Because the economy goes through stages of growth and contraction (see chart at bottom), these “cyclical” stocks also go through natural business cycles that alternate between booms and busts. Examples include automobile manufacturing, homebuilders, and airlines.

A common characteristic of cyclical stocks is how they are traded by the stock market herd impressed with the short-term prospects of the business. At the top of the cycle, stocks will be priced for growth that is obviously unsustainable, at least to the objective investor with a good discounted cash flow (DCF) model. At the bottom of the cycle, stocks will frequently be trading for single-digit multiples and pessimism will be running rampant. The contrarian value investor able to “be greedy when others are fearful” will undoubtedly find some excellent stocks that have been discarded and overlooked by others.

The stock that gave me the idea for this piece is Florida Rock and Gravel (ticker: FRK), which received a cash-and-stock buyout offer from Vulcan Materials (VMC) for $67 per share. FRK initially came of interest to me as the markets suffered a correction in May of 2006, and FRK slid into the $40s. With news surfacing about the imminent collapse of the real estate bubble and the inevitable slowdown in new housing starts, FRK seemed like a natural stock to focus on, especially because it is based in Florida, which had/has an absolutely sizzling real estate market. At the time, my valuation model put FRK shares worth approximately $55, so a sizable difference already existed between market price and my fair value estimate. The sell-off of FRK stock was not over though, and the stock feel into the $30s, a decline of over 40% in 3 months. Rerunning a DCF model showed that the market was pricing extreme pessimism into the shares of Florida Rock and Gravel, and this was the kind of pullback to buy. Ratio analysis showed FRK was a well-run company trading at a sizable discount to fair value, and although the housing slowdown would have a negative effect, investors were acting as if the company had no prospects for future growth. Fast forward a few months later, and investors have realized that the housing market may have slowed for the time being, but there is still plenty of money to be made. FRK shares were already on their way to recovery before the buyout offer from Vulcan, having recently retested $50.

What can you do to “buy the bottom” of a cyclical stock in the future? Foremost is to maintain a healthy contrarianism. Getting swept up in this quarter’s problem obscures the long-term potential of many excellent companies that are simply in tough operating environments. Oftentimes, the cyclical decline shakes out many of the weaker players in a business, leaving room for the stronger companies to profit on the recovery; make sure the company you are investing in is good enough to survive the shakeout. Buying “best of breed” is especially important here, even if it looks comparatively expensive to related stocks.

Pay attention to intra-industry mergers and acquisitions, specifically how they are financed. If an acquiring company uses cash instead of stock, then they believe their own shares are underpriced. Vulcan’s takeover of Florida Rock is being financed with 30% stock, meaning that they believe their shares are modestly undervalued right now. Conversely, at the top of the cycle, deals will be financed with stock — because the stock is overvalued, so the acquiring company is using the assets valued at a premium over true worth.

Finally, remember that the key to understanding the value of a stock is to know the profitability from a normal earnings year — a requirement that makes valuing cyclical stocks more difficult because it is difficult to define a “normal” year.  Valuation is said to be part art and part science, and I think valuing cyclical stocks is more “art” than usual. It takes plenty of time and experience to do properly, so practice (there is nothing wrong with tracking hypothetical picks as a learning experience) and always leave a good margin of safety.

 

Some Related Stocks: Cemex (CX), Builders’ FirstSource (BLDR), Home Depot (HD), Lowe’s (LOW)