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).

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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