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Cyclical Stocks and Magic Formula Investing

NEW YORK ( -- There's no two ways about it: The Magic Formula® Investing strategy identifies a lot of cyclical stocks.

A cyclical company is one that experiences wider-than-normal variations in its level of sales, due to the inherent boom-and-bust nature of its underlying industry and, sometimes, the overall macroeconomic conditions in the world.

Usually, MFI will turn up a cyclical stock well into the boom portion of the cycle, after above-average profits have been booked but right about when investors think the boom will moderate or end, which brings the stock price down.

Bingo: the magical combination of a high earnings yield and a high return on capital.

One key thing to determine when analyzing a cyclical stock is the nature of its cost structure.

These companies will skew in one of two directions: toward a fixed cost structure or a variable cost structure. Let's take a look at each and the advantages and disadvantages.

Fixed Cost Structure: Kronos Worldwide (KRO)

A fixed cost structure means that most of the costs needed to generate revenues cannot be reduced rapidly when sales decline.

On the flip side, these costs do not need to go up much in boom periods, and this creates what us investment geeks like to call "cost leverage."

In a nutshell, during boom periods a fixed cost structure can generate huge profitability, but during bust periods these firms can easily suffer operating losses.

A current MFI example is Kronos Worldwide, a global producer of titanium dioxide, or TiO2.

Kronos builds and owns the industrial plants it uses to produce TiO2. TiO2 is a commodity product with historically wide price swings.

Whether prices are low or high, Kronos still has to pay roughly the same amount of money to run those factories.

As a result, gross profit margins are highly variable and dependent on sales levels, as costs cannot quickly be cut.

Look at Kronos over the past five years:

In 2008-09, a number of TiO2 producers reduced capacity at higher operating cost facilities, due to both the ongoing recession and new, more stringent environmental regulations (these are highly polluting factories).
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