Cyclical stocks: Cash out in time

Cyclical stocks are well known for both wealth creation and wealth destruction. For example, sugar, chemicals, metals and resources (coal, iron ore, etc.) are predominantly cyclical businesses. Unlike FMCG goods, pharmaceuticals or banking credit (which normally keep rising their demands over the years), the demand-supply forces of these cyclical businesses adjust quite fast for variations in each other force. Accordingly, their market caps also behave in a cyclical fashion.

For example, the prices of both natural rubber and crude oil (from which synthetic rubber is derived) stared moving downward substantially from 2013. Being cyclical in nature, the severe fall in the prices of these two resources led to re-rating of PE multiple for the tyre stocks from as low as 4 to over 10 times. In the process, many tyre stocks multiplied their stocks prices over 10-folds. However, crude oil price bounced more than 150% from its 2016 bottom. Still tyre stocks consolidated their gains as their output is not as cyclical as their inputs.

However, the risk of wealth destruction is enormous when the final products (like sugar, resources, chemicals, etc) are themselves cyclical in nature and the retail investors do not understand the need to adjust the valuation multiples for extreme variations in the business cycles.

Only about six to seven months ago, most sugar stocks hit record high market caps. But in a matter of just six months, the market caps of many sugar stocks have crashed 50% to 70%. Investors in such stock sugar stocks need to now wait for another upturn in sugar business which may come at the fag end of 2019 or may even take another two to three years. It is also doubtful whether the investors, who bought these sugar stocks at the peak of the prices, would recover their costs fully in all cases even after two or three years!

Now after sugar, many chemical stocks – especially stocks of companies engaged in phthalic anhydride, graphite, carbon block, etc- have moved up manifold in the last three years. In case of sugar industry, whenever the sugar prices peak out, the farmers tend to maximize the area under sugar cane crop, which in turn leads to oversupply of sugar in the country. Before excessive supply of sugar hits the markets actually, the sugar stocks fall very badly.

Similarly, whenever, chemical prices shoot up substantially, many producers across the world restart or expand their supplies vigorously. For this reason, many chemical companies, which are engaged in producing chemicals like phthalic anhydride, carbon black, etc., have seen their profits as well as market caps plunging as high as 50% from their previous peaks quite periodically in the last 15 years. Hence, it would be wise for the retail investors to take out profits at the peak of valuations quite periodically from the cyclical chemical stocks.

The writer is founder and managing director, Equinomics Research and Advisory