Load Up on These Cyclical Stocks

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Dave Sterman

NEW YORK ( StreetAuthority) -- Although the U.S. economy has recently been on an unpredictable path, get ready to see more typical economic patterns take root. The economy is just get its footing now and should be a bit better in 2013. And, if history is any guide, it will have practically recovered by the middle of this decade.

To be sure, a lot of companies are still speaking of challenging industry conditions, but remember that "investors always look ahead." So they will soon start buying up companies that tend to really benefit when the economic cycle is in a clear upward phase. Smart investors will want to begin looking at these stocks now.

Tricky to Value

At first blush, these cyclical stocks may not seem especially cheap relative to the rest of the market. They have to sport medium- to large-P/E ratios on near-term results, but need to be valued against what they might earn when the economy is on strong footing, known as "peak-cycle profits." These stocks rarely trade for more than 10 times peak-cycle earnings, so several bargains abound when using this yardstick.
Alcoa could double in price once it starts to hit its stride

Take Manitowoc ( TWI) as an example. This maker of cranes and other construction equipment saw sales and profits start to rise early in the last decade, hitting the peak of the cycle in late 2007 and early 2008.

At the end of 2003, this stock looked expensive, trading for more than 90 times profits. At the end of 2004, the P/E ratio was a still-high 25 -- based on trailing earnings -- but 3.5 times what the company would generate by 2007. The fact that the stock ran to $45 by November 2007 (before a year-end pullback to $36.67) was a clear case of too much investor enthusiasm.

This stock is now below $14, and by using the rule of thumb of a peak-cycle P/E ratio of 10, it could move up to $25 or $30 in the next few years. "There is still substantial upside to a 2014E mid-cycle value of $23 in a continued U.S. nonresidential recovery," Goldman Sachs analysts note. They say we won't see the peak of the cycle until a year or two after that, so shares will likely move past that price target once analysts actually start speaking of peak-cycle results.

Joy Global ( JOY) is another deeply cyclical stock that could rise steadily higher as the economy strengthens. Shares of this mining equipment firm have fallen nearly 20% since late January to a recent $79, but could power into the triple-digits in the next 12 to 18 months.

Investors have been concerned that a drop in demand for coal would negatively affect sales for this company's coal-mining equipment. But they may be overlooking the fact that a steady spate of acquisitions has pushed Joy Global's exposure to the coal-mining industry to less than 25%.

Analysts see Joy Global's earnings rising from $6 per share in fiscal (October) 2011 to roughly $8.50 per share by fiscal 2013. If history is any guide, then this figure could hit $11 or $12 by the middle of the decade, and shares will eventually be valued at around 10 times that peak-cycle number.

Analogies to the past cycle don't necessarily apply here. In recent years, Joy Global has made a series of acquisitions that should push sales and earnings per share (EPS) well above the previous cycle peak. For example, the company is expected to generate $6.4 billion in sales by fiscal 2013, and perhaps $8 billion by the middle of the decade. This is well above the $3 billion in average annual sales seen in fiscal 2005 through fiscal 2008.

Of course, my favorite deeply-cyclical stock is Alcoa ( AA), which is affected by unit volumes and unit pricing.

In the last cycle, in 2007, sales peaked at around $29 billion, while EPS hit $3.24. Sales have now fallen below $25 billion, and it's the $4 billion difference in revenue that really explains the profit swing, as Alcoa had been selling aluminum at far above cost back in 2007. These days, Alcoa's EPS is stuck in the $0.50 to $0.75 range.

I added this stock to my $100,000 Real-Money Portfolio , not because I expect to see Alcoa earn $3 a share any time soon. But I fully expect EPS to approach $2 by 2014, thanks to industry supply cuts that will eventually boost pricing.

This stock could head to $20, or 10 times my peak-cycle forecast and roughly double where the stock sits now. The fact that this stock touched $40 in early 2008 tells you how enamored investors can become of deep-cycle stocks once they are hitting their stride.

Risks to Consider: These companies won't truly hit their stride until Europe has exited its current recession. This may not happen before 2013 or 2014.

Action to Take --> These are just a few examples of deep-cycle plays. Other stocks to research include Caterpillar ( CAT), Cummins ( CMI), Eaton ( ETN) and Honeywell ( HON). None of these stocks looks like a bargain in the context of likely 2012 results, but all could move up sharply as investors grow more confident that the economy is building a head of steam as we move toward the middle of the decade.

David Sterman does not personally hold positions in any securities mentioned in this article.

StreetAuthority LLC owns shares of AA in one or more if its "real money" portfolios.

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