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Beating the Street: Peter Lynch on Cyclical Stocks

We all know it happens. The share prices of cyclical companies fall during recessions and rise during booms. Obviously, if we could always buy at the bottom, we would have a distinct edge in the market. Alas, it's much harder to do in practice than in theory.

Someone who has beaten the odds and done it quite successfully is Peter Lynch, the manager of Fidelity's Magellan Fund between 1977 and 1990 and author of "One Up on Wall Street" and "Beating the Street." His mastery of cyclicals was one of the reasons he was able to average annual returns of 29.2% over the 13 years he ran Magellan.


Regarding cyclicals, he noted in chapter 15 of "Beating the Street" that they provide a well-known pattern and are as reliable as the seasons. However, "What confuses the issue is the fund manager's perpetual itch to get ahead of the competition by returning to the cyclicals before everybody else does. It seems to me that Wall Street is anticipating the revival of cyclical industries earlier and earlier before the fact, and this makes investing in cyclicals a trickier and trickier proposition."

His starting point for analyzing cyclicals was the price-earnings ratio; usually, a low price-earnings ratio is attractive when buying stocks, but not when buying cyclicals. A very low price-earnings suggests a cyclical's good times are about to end. Unsophisticated investors continue to hold these stocks because business is still good, though change is brewing below the surface.

On the other hand, a high price-earnings suggests a cyclical stock is going through the trough and business should improve soon. That means fund managers will begin buying again, pushing the price up. As Lynch explained:


"The fact that the cyclical game is a game of anticipation makes it doubly hard to make money in these stocks. The principal danger is that you buy too early, then get discouraged and sell. It's perilous to invest in a cyclical without having a working knowledge of the industry".



Phelps Dodge

To illustrate how he analyzes a cyclical stock, Lynch offered the case of Phelps Dodge (now owned by Freeport-McMoRan (NYSE:FCX)), a major copper producer. In 1991 and 1992, no one was predicting the company would rise out of its trough, but Lynch sensed that copper prices would go up as the economy recovered. After confirming with his plumber that the price was indeed going up, he believed he had an opportunity to get an early edge on its recovery.

And there was broader support for rising copper prices than just a cyclical shift. Smelters were becoming scarcer because of environmental regulations. There was already a shortage of them in the U.S., and a shortfall was emerging in other countries as well. This was at a time before fiber optic cables became popular, so there was also strong demand for copper for telephone wires.

The company's balance sheet was solid. According to Lynch, the company had $1.68 billion in equity and only $318 million in debt. It would not have to refinance if the economy did not recover.

It was a diversified company, and Lynch wanted to know about the other areas in which it did business. In a phone call with the CEO, he learned that its carbon black division was okay, as were the magnet wire and truck wheel divisions. It also held a 72% stake in Canyon Resources (ASX:CAY), which had a gold mine in Montana with excellent prospects.

By his calculations, the wholly-owned subsidiaries were worth $10 to $16, while the stake in Canyon might be worth another $5 per share. He added,


"I often do this sort of thumbnail appraisal of a company's various divisions, which may represent a sizable hidden asset. This is a useful exercise to perform on any sort of company whose shares you might want to buy. It's not unusual to discover that the parts are worth more than the whole."



In this case, it was a useful exercise: If the other Phelps Dodge businesses were worth $15 to $21 per share, while its share price was around $32, the copper business would cost very little--from $11 to $17 a share.

Next, Lynch wanted to know about capital spending, which has ruined other industrial companies. In this case, capex was less than half its cash flow. In addition, all its mines and facilities were in excellent condition, so little spending would be required to maintain them.

On the revenue side, the company produced 1.1 billion pounds of copper a year and had 70 million shares, so if the price went up by one cent per pound, after-tax earnings would increase by 10 cents per share. If the price of copper went up by 50 cents a pound, after-tax earnings would increase by $5 per share. The latter would be an excellent return if the copper part of the business had cost $11 to $17 per share.

Conclusion

In chapter 15 of "Beating the Street," Lynch took on the tricky issue of making money with a cyclical business. He used the example of Phelps Dodge to show his thinking.

He began with an assumption that the economy would recover, and that when it did, copper prices would recover as well. He confirmed at the grassroots that prices had already started to inch up, and external factors reinforced his belief the price would have to go up.

Lynch also did a financial analysis. One of the keys was to assess the value of its non-core companies, which showed him the price of the copper business was well below the share price. Further, he figured out the revenue model, and how each incremental increase in the price of copper would push up Phelps Dodge's after-tax earnings.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.