Cyclical Investing's Countercyclical Payoff: Street Whispers

NEW YORK ( TheStreet) -- Private equity giant Apollo Global Management's ( APO) investment success in chemicals conglomerate LyondellBasell ( LYB) shows what big money private equity has discovered and what retail investors have yet to realize: Cyclical stocks can tell you the direction of corporate earnings but that doesn't mean they say anything about valuations.

By looking at chemical giant LyondellBasell's continued recovery from bankruptcy and gains made by its private equity and hedge fund shareholders since an October 2010 initial public offering illustrate that confusion may abound about cyclical stock valuations.

Be it steel manufacturer Alcoa ( AA), chemicals giant DuPont ( DD) or equipment maker Caterpillar ( CAT), cyclical's are rightfully seen by investors as leading indicators for corporate earnings and the overall economy.

But as a read on the direction of stock market valuations, cyclical stocks may be the exact opposite. In fact, a look at the private equity and hedge fund score in LyondellBasell stands as proof of a crucial, but counterintuitive investing dynamic. While Apollo invested in LyondellBasell at peak valuation multiples, it also entered the company as it neared cyclical earnings lows after the onset of the Great Recession.

Now, many expect that the opposite. In fact, after a string of blockbuster earnings quarters in a shaky economy, continued optimism on LyondellBasell's shares hinge on whether its multiple rises as earnings peak.

The counterintuitive interplay between earnings and valuations is the key, after LyondellBasell reported better than expected second quarter earnings in late July. " We continue to believe that at 4.8x our 2013 EBITDA earnings before interest, taxes, depreciation and amortization forecast for the stock is reflecting more peak-like earnings despite the fact that we are below mid-cycle levels that should improve over the coming years," wrote Credit Suisse analyst John McNulty, in a note to clients after LyondellBasell's July 27 earnings.

Apollo's entry point into LyondellBasell came as markets and the global economy turned from a boom to the biggest bust since the Great Depression. Saddled with a $30 billion in debt from a leveraged 2007 merger between Houston-based Lyondell and Basell of the Netherlands, a subsidiary of investing conglomerate Access Industries, the company quickly suffered from downturn and was forced into bankruptcy.

When making an initially mistimed 2008 investment in LyondellBasell's debt and a subsequent push for equity control in its 2009 bankruptcy, Apollo faced an investment in a company with negative earnings and cash flow that made it expensive on classic valuation multiples.

But when projecting LyondellBasell's future earnings or by studying its trailing results, Apollo likely saw a bargain-priced company in 2008 and 2009. Now, if ordinary investors see the company's current low earnings multiples as a similar bargain they are misguided.

Credit Suisse's McNulty makes the argument that while the company's valuation of less than five times EBITDA looks like a cyclical low, that's only because earnings are churning at a cyclical high. In his continued optimism on LyondellBasell shares, which have gained nearly 50% in 2012, the analyst makes the point that if earnings have topped out, he expects valuations haven't.

For instance, while McNulty recently cut his estimate of 2013 and 2014 earnings, implicit in his 'Buy' recommendation of LyondellBasell shares is a rise in the company's earnings multiple.

In this counterintuitive investing dynamic no one has more at stake than Apollo.

Apollo's near 30% stake in LyondellBasell is worth roughly $9 billion and it comprises almost half of the private equity firm's largest fund. Meanwhile, the fund's 33% investment gain, driven by its LyondellBasell investment, accounts for nearly 20% of the firm's total investing profits over its 20-year plus history, according to its latest earnings.

Other large LyondellBasell shareholders include private equity fund Access Industries, which maintained a 14% stake in the company after ceding control of it to Apollo in bankruptcy. Hedge fund investors Viking Global Management and Ares Management own roughly $500 million of the company's stock.

Apollo's investment in LyondellBasell spans a complicated Wall Street saga that includes a leveraged buyout and an industry-rattling bankruptcy -- but the firm's investment success boils down to properly understanding the interplay between cyclical earnings and valuations. That has a strong relevance to the ordinary investor.

-- Written by Antoine Gara in New York

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