Mission Impossible? The Trials and Tribulations of Valuing Cyclical Stocks

Let's go over the reasons why you should <I>not</I> jump on the cyclicals bandwagon.
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Investors have probably had it with the recent media bombast about the return of two notable market laggards: cyclicals and value stocks. I took my own

shot on this subject a month or so ago, in one of my rare (and successful!) attempts to comment on shorter-term market trends (but don't think this will become a habit).

But because the past six weeks has seen the continuation of this violent upward move in cyclical stocks, you may be thinking there's something to this cyclical/value-stock move after all, and you just may be considering what -- if any -- action you should take.

First off, let's separate the terms. There is no

a priori

condition that says cyclicals represent value, and it's a misnomer to categorically state that all value managers own lots of cyclicals. Cyclical stocks are named as such because their earnings gyrate wildly depending upon the economic environment. Sometimes they represent value, sometimes they don't.

And remember that value is in the eyes of the beholder. On one end of the spectrum we have

Bill Miller

, who considers

America Online

(AOL)

a value stock and holds gobs of it in his

(LMVTX) - Get Report

Legg Mason Value Trust. On the other end of the spectrum there's the

(VWNDX) - Get Report

Vanguard Windsor Fund "House of Cyclicals." Six weeks ago, I would have argued that the stars were in proper alignment and, yes, cyclical stocks did represent value. So a correct analysis of the past six weeks is that we have seen a violent upward move in cyclical stocks that many value managers happened to own.

Cyclicals fall into two camps. Stocks like

3M

(MMM) - Get Report

and

Dover

(DOV) - Get Report

are cyclicals because the companies' business segments are so broad that they are proxies for the economy. In 3M's case, having flat earnings in a tough economic environment with operating margins in the high teens and a 20% return on capital isn't exactly a cry of poverty. I'd call these kinds of companies growth cyclicals -- and if you're a long-term investor, they can be core holdings that you buy cheaply in tough times to be owned in relative perpetuity. You might take fat positions near the bottom of economic troughs and lighten up a few years later when economic conditions are wonderful.

Next, we have big cyclicals like

Alcoa

(AA) - Get Report

,

Nucor

(NUE) - Get Report

,

International Paper

(IP) - Get Report

and

Dow Chemical

(DOW) - Get Report

, which represent ownership in commodity businesses. You should treat them as stocks to rent, not to own. As

Warren Buffett

has eloquently noted in a number of

Berkshire Hathaway

(BRK.A) - Get Report

annual reports, the problem with commodity businesses is that you're subject to the behavior of your worst competitor. There are huge fixed costs, and even minor changes to how you run your plants translates into large earnings variability or actual losses. Therefore, poor management can be goaded into running plants at full capacity even when demand is far less than supply.

That's why management is key when you're considering whether the cyclical move has legs -- or if it's a stunning value catch-up that's about to run out of steam. The question to ask is: Has management in cyclical industries learned the capital allocation lesson? In the post-war era the management of most cyclical industries seems to have had little regard for return on capital and has built uneconomic plants when pricing and profitability look good. In complete ignorance of game theory, a company determines that if it builds a plant, no one else will, and therefore it'll reap the incremental returns of selling additional capacity at spiffy prices. What happens, of course, is that everyone builds a new plant and all suffer.

With the truly dismal returns of most commodity businesses in the 1990s and the increasing protests from institutional investors have come some major changes in the way companies think. A number of chemical companies have formed joint ventures to build new plants instead of going it alone.

Other companies are taking new approaches.

Georgia Pacific

(GP)

, for example, says it's following an economic-value-added model and won't build stupid new capacity. The company also has created a tracking stock for its timber holdings and has walled off that cash flow from its paper businesses, forcing its paper managers to make more intelligent investment decisions. There have been numerous takeovers in the forest products industry worldwide -- International Paper/Union Camp, for one -- which, in theory, puts a higher percentage of industry assets in smarter hands. In theory.

Investing in cyclical companies requires a different take on analytical tools. Buying a cyclical stock with the thinking that it's selling at seven times earnings -- "so it must be cheap" -- is a recipe for disaster. You should buy cyclicals when price-to-earnings ratios are sky high or because losses are being incurred -- because that means we're near the bottom of the cycle.

To get a good understanding of a cyclical stock, look back through about 10 years of the company's financials. Calculate its return on assets, or ROA -- net income divided by average assets -- in its worst and best years. Take the midpoint and multiply that number by the company's

current

asset base. What that gives you is a rough proxy of the company's mid-cycle earnings. As a final step, value those earnings at a mid-cycle price-earnings ratio of 15, and see how that figure compares to the current price.

It's also useful to know a peak earnings capacity for a cyclical. To do this, simply take the return on assets from the highest ROA year and calculate what that percentage return would produce, based on the asset base in 1998. To translate that into a current value for the stock, multiply those earnings by a P/E of 8 to 10 times -- which is about all you should pay for a cyclical's peak earning capacity.

Using Dow Chemical as an example, you get a peak earnings number of $15 to $17 per share, which, when multiplied by a P/E of 8 to 10 times earnings, provides you with a peak valuation of $120 to $170. Figure that if all goes well with the world economy, Dow should hit this number in 2002. Discount those earnings back to today, using a 10% discount rate, and you get a present value for Dow of $90 to $127. The current stock price is about $130. Hmm.

This method for determining a cyclical stock's value is simplistic, but not entirely off the mark. In all candor, Dow may not be the best example for this analysis, because management has done a terrific job of focusing on return on capital in its petrochemicals businesses. The company argues, in fact, that a big chunk of its business is in specialty areas and bio-agriculture, which deserves much higher multiples. We'll see.

The lure of cyclical investing is that if you buy right and hit the economic cycle correctly, the earnings leverage is unbelievable. One of my earliest professional coups was in

Reynolds Metals

(RLM) - Get Report

, where earnings estimates for the next fiscal year were $2 per share. They ended up earning near $10 per share, and the stock flew as skeptical analysts ended up raising earnings estimates every week and the stock went up five-fold. Fortunately, I'm not allocated nearly enough space to share with readers my long list of

un

successful ventures in big cyclicals.

The message is that making a successful career out of profitably investing in cyclicals is a low-probability game. You have to get both the buy and the sell right, which is never easy. Making a base case that, after a 60% move in many cyclicals, now is the time to get in, requires a level of conviction in your ability as an economic forecaster that few have demonstrated over any period of time.

Jeffrey Bronchick is chief investment officer of Reed Conner & Birdwell, a Los Angeles-based money management firm with about $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value fund. At time of publication, neither Bronchick nor RCB held any positions in the stocks discussed in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at

jbronchick@rcbinvest.com.