Core Concepts: Machinery Peaks and Troughs

In my column last week, I urged readers to take advantage of investors' linear bias. Investors tend to extrapolate peak and trough conditions into the distant future, which is a proximate cause for both overvalued and undervalued stocks.

If you study the 10-year history of stocks in the machinery sector, you'll see that this linear bias is an overwhelming influence. The effect is dramatic in most of the machinery stocks, including category leaders like Caterpillar (CAT - commentary - Cramer's Take) and Cummins (CMI - commentary - Cramer's Take).

Peaks and Valleys at Caterpillar

Caterpillar's operating trough occurred in 2001-02. A trough occurs when operating metrics such as sales growth, profit margins and return on equity are well below normal. Because of the market's linear bias, trough operating conditions are priced into a stock as if the tough times will never end. As you can see in Caterpillar's price history, the 2001-02 operating trough coincided with a low in the stock.

Caterpillar Here's a 10-year chart

The opposite is also true: Peak operating performance often coincides with highs in the stock price. However, it's too simplistic to say that companies operating at peak levels should always be sold. High-quality operating models -- those that generate consistent organic growth or those that have monopoly-like characteristics -- can continue at peak levels for extended periods of time. Examples include Starbucks (SBUX - commentary - Cramer's Take), Costco (COST - commentary - Cramer's Take) and Coca-Cola (KO - commentary - Cramer's Take).

The key takeaway is that risk escalates when a company is enjoying peak operating conditions. Again, Caterpillar's history illustrates the point. Peak operating conditions existed during 1997-98. Operating margins, at nearly 19%, and net margins, at 8.8%, were at record levels. Caterpillar's return on equity surpassed 35% during this period, an amazingly high level for this sort of operating model.

Operating performance at Caterpillar gradually declined from the 1997-98 peak to the decidedly subnormal trough of 2001-02. As you can see from Caterpillar's price history above, buying in tough times and selling in periods of peak performance can be a profitable strategy. This goes against the crowd mentality, as investors are readily attracted to companies that are thriving and are reluctant to invest in those that are struggling.

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At time of publication, Alsin and/or ACM had no positions in the stocks mentioned, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.