Education: Value Investing

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Assessing Value for Cyclical Stocks

You have contemplated purchasing a stock that has posted spectacular earnings as of late. But you are concerned because previously this same company went through a very dismal period—posting losses for a few years in a row. Looking even further back, you quickly notice a pattern. This particular company often experiences a series of up years followed by a series of down years, followed by a series of up years—a roller coaster of a stock. How do you value a stock with such unsteady earnings?

Cyclical versus Non-cyclical

The performance of cyclical stocks is closely tied to the performance of the overall economy. They tend to rise quickly when the economy is hot and plummet when the economy turns sour. It only makes sense that companies falling into this category produce, market and/or sell products and services that are highly coveted when people are making good money. The housing, automobile and airline industries are commonly referred to as cyclical.

On the contrary, the products and services of non-cyclical companies represent those that consumers and businesses can’t put off no matter what the current state of the economy is. These are commonly referred to as defensive stocks because they can still do well even when the economy is hurting. Utilities (water, gas, electricity) and non-durable goods (toothpaste and toilet paper) are often pointed to as classic examples of non-cyclical stocks. While these stocks tend to lag the market during economic booms, when the economy turns south, investors love their steady performance.

Assigning a Price Tag

With the roller-coaster action of cyclical stocks, and their corresponding erratic earnings, how can one possibly assign a value to such a group?

Benjamin Graham, commonly referred to as the “Dean of Wall Street” or the “Father of Value Investing”, argued that when valuing a cyclical stock, an investor should take the company’s average earnings over the past 10 years. This would represent the length of a typical business cycle. The five stages of the business cycle are growth (expansion), peak, recession (contraction), trough and recovery. While Graham’s may not be a perfect metric, it can serve as a handy guide.

There are obvious exceptions to Graham’s philosophy. One need not look further than the 1990’s. The market, as represented by the S&P 500, experienced quite an impressive bull market during this time period. When calculating Graham’s average during this time period, perhaps you may overstate your estimate. The same can be said for an unprecedented bear market, in which an estimate may be understated. Adjustments will have to be made. While Graham was one of the most successful investors of all time, he was by no means perfect.

Help Is on the Way

Investing in cyclical stocks, as you can imagine, can be very risky. Needless to say, careful timing is mandatory. If you get in at the wrong time, you can lose a ton of cash. Lucky for you, we at Zacks have developed a quantitative ranking to help you avoid such a disaster.

The Zacks Rank is a quantitative model that uses four factors related to earnings estimates to classify stocks into five groups, ranging from “Strong Buy” to “Strong Sell”. Yes, it is that clear. We tell you when to buy and when to sell. Zacks #1 Rank stocks had an average annualized return of +32% since 1988. Furthermore, during the bear market of 2000-2002, Zacks #1 Rank stocks gained +43.8%, while the S&P 500 tumbled -37.6%. Learn more about the Zacks Rank

So, while it is impossible to predict which way the economy is heading, the Zacks Rank can at least help you predict which way your stock is heading.