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Cyclical Stocks and Magic Formula Investing

As a result, inventories dropped, but demand for TiO2 has not -- quite the opposite, in fact. As a result, Kronos has been able to operate its plants at higher utilization while enjoying a 50% rise in the commodity's selling prices!

Clearly, the above table shows how gross margin percentage is closely tied to sales levels, a sure sign of a highly fixed cost structure. The downside is that, should TiO2 prices fall again, those margins will come crashing down again.

Variable Cost Structure: Kulicke & Soffa (KLIC)

The alternative to a fixed cost structure is a variable one.

Here, product costs generally scale to the absolute level of sales.

The advantage of this is that, during bust periods, costs also drop rapidly, which protects profitability and guards against the damage of big operating losses.

The disadvantage is that these companies do not gain as large a financial windfall during boom periods.

A Magic Formula Investing example here is Kulicke & Soffa, which builds equipment for packaging semiconductors.

Unlike Kronos, K&S does not own the factories to build its equipment and instead focuses on design. It contracts production to third parties.

Demand for semiconductor equipment follows dramatic boom-and-bust periods, where suppliers quickly ramp up capacity to meet forecast demand, and then there is a lull while demand actually builds to those levels.

The last five quarters is a good example of this boom-and-bust cycle, and a table illustrates the firm's variable cost setup:

Despite a revenue swing of almost 250% during this span, gross margin remains the same at right around 46%, meaning the company has very few fixed costs in producing its products. This helps maintain profitable operations even in down periods.

So Which Is Better?

There's really no right answer as to which is better, but a variable cost structure has fewer acute risks.

One particular situation to watch for is a heavy cyclical with a fixed cost structure and a lot of debt.

When sales go south, the firm may rapidly find itself unable to meet its interest obligations or to redeem or refinance debt that reaches maturity. This is the exact kind of situation that led two of the three Detroit automakers (all cyclical, fixed-cost companies) into bankruptcy in 2009.

At the time of publication, Alexander held no positions in stocks mentioned.
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