Stocks Hitting a Cyclical Sweet Spot

In the stock market, false starts can be gold mines.

Look no further than the chemicals sector. This sector, which took off in late 2001 on hopes that the economy was ready for a rebound, has sagged in 2002 on fears that the rebound is further away than expected.

But that's exactly what has created a buying opportunity in the sector. The pullback has taken a good part of the risk out of these stocks. When market sentiment swings again toward a belief in an economic rebound, these stocks are likely to recover all the ground they've lost, and then some.

It's time in the market cycle to bet on cyclicals again. And in this column I'll give you seven stocks -- in chemicals, paper and steel -- that are good candidates to lead the stock market out of its current doldrums.

Through the end of the year, the cyclical group was keeping pace with the red-hot rally in technology stocks from the Sept. 21 bottom. Investors had bid the tech-dominated Nasdaq Composite up 37% from that date through the end of the year. Cyclical stocks in general -- industrial companies that supply raw materials traditionally climb when it looks like a sour economy is about to turn sweet -- kept pace with the Morgan Stanley Cyclical Index, climbing 27% for the period. And chemical stocks had been among the best performers.

Rohm & Haas (ROH Quote) climbed 34%, Praxair (PX Quote) was up about 47%, and A. Schulman (SHLM Quote) was up 51%. Even ol' laggard Dow Chemical (DOW Quote) managed a 16% gain.

The January Thaw

But then the warnings hit. On Jan. 3 Dow Chemical said that fourth-quarter earnings, already expected to be a dismal 13 cents a share, way below last December's 36 cents a share, would be 10 to 20 cents below forecasts. Chemical prices, which trend up when the economy picks up, continued their downward course in December, month-end figures showed. Ethylene and propylene were flat or lower in December from November. The price of plastic resins fell in the month. By the time Cytec Industries(CYT Quote) reported on Jan. 8, the sector was already in free-fall.

From the close on Jan. 7 through the close on Jan. 18, Cytec fell 11%, Rohm & Haas and Praxair tumbled 12%, and Dow Chemical plunged 25%. That last ride downward was juiced by fears that Dow was about to get smacked with a new round of asbestos liability.

Relax if you can. This kind of gut-wrenching ride is business as usual for a stock market that's trying to call a turn in the economy. Hopes that a recovery is just around the corner produce sharp rallies that are followed by almost-as-steep pullbacks when fears take over that the turn is further off than expected.

And it's time to buy into cyclical stocks when the fears temporarily overwhelm the hopes. Playing the ups and downs of sentiment at a time like this is the best way to maximize return and minimize risk.

To make the right buys (and sells, since these stocks aren't buy-and-hold candidates by any means), investors can start with the three factors: time, leverage and valuation. Here's how they play out for industrial cyclicals right now.

Time is on this sector's side at the moment, because evidence continues to mount that the economy is beginning to turn around. The index of leading economic indicators, for example, rose 1.2% in December for its third consecutive monthly gain. The jump was the largest monthly increase since February 1996. Economists believe that three upward movements in the index usually indicate that the economy will expand in the next three to six months. And finally, for what it's worth, Federal Reserve Chairman Alan Greenspan told Congress last week that the economy is on the mend.

Strong Profit Forecasts

Industrial cyclicals show the same kind of powerful potential upside operating leverage as the technology stocks I wrote about in my last column. Sanford Bernstein, for example, is projecting Rohm & Haas will earn $1.05 cents a share in 2001, down from $1.48 in 2000. But 2002 will bring a 50% rebound in earnings per share, according to Bernstein, to $1.85 a share. You can find the same kind of upside potential in Dow Chemical (61 cents a share in 2001 but $1.30 in 2002), Georgia Gulf(GGC Quote) (a loss of 41 cents in 2001 but earnings of 25 cents a share in 2002) and Great Lakes Chemical(GLK Quote) (46 cents in 2001 but 75 cents a share in 2002).

Valuations aren't cheap at this point in the economic cycle, but the recent pullback makes these stocks interesting again. For example, before the pullback, Rohm & Haas was trading at 20 times projected 2002 earnings per share. That was well below the stock's absolute historical high price-to-earnings ratio of the last five years of 27, according to Lehman Brothers, but still well above the stock's average multiple of 17. Investors who bought at that price were buying in hopes of a surge in valuation toward that historical high, and that's a dangerous hope this early in the economic cycle, in my opinion.

But after the recent pullback, Rohm & Haas is trading at 17 times projected 2002 earnings per share, or exactly the historical average. That leaves a lot more upside within the historical range for the stock -- and reduces the downside as well.

Having time, leverage and valuation on your side in a sector means investors can buy with the conviction that the wind is at their back rather than blowing against them. But in buying individual stocks, I seek more than just favorable sector momentum. I look for stocks with individual catalysts that have the potential to drive the price upward over the next six months. And I try to avoid stocks with looming potential dangers that might sink the shares of an individual company even as the sector itself climbs.

So, for example, in the chemical sector I like Praxair, Air Products (APD Quote) and Rohm & Haas, because each combines new growth opportunities with significant cost-cutting. That adds up to big potential increases in earnings per share in 2002 and 2003.

Praxair's new CoJet technology, for instance, has opened up new markets for the company in the steel industry; CoJet is projected to save steelmakers $5 a ton, and the company has already signed more than 40 contracts with mini-mills and made its first deal with a big integrated steelmaker. Further growth should come from the medical gas market. The company has made four recent acquisitions in the medical home care services market -- a sector that's growing at 8% to 10% a year. On the cost-cutting front, the company has been actively shedding underperforming units and has made investments in energy conservation -- 70% of the operating cost at an air separation plant goes to energy -- and in process controls to improve productivity.

The story is much the same at Air Products, where a rebound in the electronics industry could drive earnings to $2.50 a share in 2002, and where a new CEO has provided much-needed discipline on costs. At Rohm & Haas, the potential catalysts include $200 million in annualized cost-cutting efforts and a rebound in the company's sales to the electronics industry.

Bargains in Paper and Steel

I've focused on the chemical sector, but I think you can find the same positive catalysts at other individual companies in attractive cyclical sectors. In the paper industry, International Paper(IP Quote), Smurfit-Stone Container (SSCC Quote) and Bowater (BOW Quote) fit the bill. In steel, Nucor (NUE Quote) pops to the top of the list.

But before you buy anything, remember to complete the last step in this five-step process and take a long look for anything in an individual company's business that might blow up on you. In the chemical sector, for example, I'd avoid stocks such as Dow Chemical, where investors are clearly spooked by the potential for big asbestos liability resulting from the company's purchase of Union Carbide and Great Lakes Chemical (GLK Quote), whose bromine products are facing environmental pressures in Europe.

The bankruptcy of Enron(ENRNQ Quote) in a flurry of shredded documents, the plunge in value at Halliburton(HAL Quote) and Dow Chemical because of asbestos, and the collapse of Kmart(KM Quote) have made investors extremely edgy. At the least sign of trouble, money heads for the hills these days, and anyone slow to the exit can be left holding the bag. So it's important to check a potential investment for red flags.

Few companies in the older industrial sectors of the economy don't have some exposure to something -- asbestos liability, an underfunded pension plan, or an overreliance on pro forma accounting, to name a few. For example, Praxair was once a division of Union Carbide -- the company acquired by Dow that is the source of Dow's asbestos headaches. Praxair's best read is that it has no material asbestos liability, though the company does believe it may have some small claims from the days when its packaged-gases division sold welding gloves insulated with asbestos. It's up to the individual investor not only to identify the potential problem but also to figure out whether it's a big deal that puts a stock on the don't-buy list.