How To Invest In Cyclical Companies

Published in Investing Strategy on 20 September 2010

Correctly timing your investment in cyclicals like this distribution company can be rewarding.

In theory, it's a simple concept to time economic cycles by investing in cyclical companies like Wolseley (LSE: WOS), the well-known distributor of heating, plumbing and building products. 

In practice, when you're in the thick of the investment battle with profit warnings whistling past your ears, it's not as easy to accurately shoot your investment bullet as the theory would suggest.

Sage advice

Legendary investor Peter Lynch, who made many investments in cyclical companies, offers the best advice that I've come across so far for cyclical investing in his book Beating The Street:

"With most stocks, a low price/earnings ratio is a good thing, but not with cyclicals. When the p/e ratios of cyclical companies are very low, it's usually a sign that they are at the end of a prosperous interlude... Soon the economy will falter, and the earnings of the cyclical will decline at breathtaking speed. As more investors head for the exits, the stock price will plummet. Buying a cyclical after several years of record earnings and when the p/e ratio has hit a low point is a proven method for losing half your money in a short period of time."

So, just at the point where the traditional value ratios look the most tempting, the share price is likely to be near to its cyclical peak. Lynch goes on to say:

"Conversely, a high p/e ratio, which with most stocks is regarded as a bad thing, may be good news for a cyclical. Often it means that a company is passing through the worst of the doldrums, and soon its business will improve ... Thus, the stock price will go up."

In a nutshell, Lynch advocates buying when earnings are low and selling when earnings are high.

Boom and bust

A peek at Wolseley's share price chart shows massive growth in the noughties as it supplied much of the stuff to satisfy the public's debt financed demand for new kitchens, bathrooms, extensions and heating systems via its trade customers. The company exaggerated the growth by funding an acquisition programme with debt.

This all worked fine until the music stopped with the credit crunch, then, pre-empting bad news flow from the company, the share price halved by the end of 2007. It then fell by a further two thirds during 2008 and reached its nadir in early 2009.

Easier said than done

The problem for investors hoping to buy near the bottom was that the company's news flow was well behind the reaction of the share price, making it hard to apply Lynch's advice. 

By the time Wolseley had released its worst final results of the recession on 28 September 2009, the share price had been on the way up again for most of the year -- part of the famous 'dash for trash' as investors tried to anticipate the 'fact' of the company's economic recovery.

To make the fast bucks, investors had to take a leap of faith and buy the plunging share price with the extent of the financial carnage and the effects of a dilutive fund raising still unknown.

What now

During 2010, Wolseley's share price has slipped back a bit, so with the latest finals due  at the end of the month and directors recently making a few tentatively positive statements about market outlooks, perhaps it is now offering investors a second chance to run a slide rule over the figures.

My guess is that the price to earnings ratio will be a long way from the low value that Lynch suggests is the best time to sell.

It seems to me that cyclical companies are at a similar stage today as they were in the the late seventies when Lynch started investing. I think he would be checking out cyclical companies like Wolseley right now if he were still in the game.

More from Kevin Godbold:

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