This is final installment of a 6-part series of articles on stocks for 2014. In the previous five installments – Part 1, Part 2, Part 3, Part 4 and Part 5, my focus was primarily on stocks of various categories that I believed were fairly valued even after the strong run that the market has had over the past several years. However, with this final installment, my focus has changed to evaluating the potential pitfalls and/or challenges of investing in cyclical stocks, or more precisely, companies.
Nevertheless, I will be highlighting two cyclical stocks, Caterpillar Inc. (NYSE:CAT) and Deere & Company (NYSE:DE), which I believe are attractively-valued cyclical stocks today. Candidly, there were many other cyclical stocks that I came across that also appeared reasonably valued. However, as I will be expressing throughout this article, I believe that cyclical stocks should be approached with both great caution, and a clear understanding of the nature of the beast.
Depending on what your overall investment philosophy and/or approach is, stocks with cyclical operating records present investors with unique challenges. This is especially true for the retired long-term, buy-and-hold oriented dividend growth investor. In other words, it can be relatively easy to buy-and-hold a company with a consistent long-term record of earnings growth and accompanying dividend increases.
This is simply because when the inevitable short-term stock price volatility occurs with a consistent grower, especially to the downside, the investor can focus on the company’s earnings strength and dividend increases that can provide them the confidence to stay the course. I think this is important, because I am a firm believer in investing for the long-term. This has little to do with trading stocks, and everything to do with positioning yourself as a shareholder owner of a great company.
In contrast, during those inevitable periods where the earnings of a company with cyclical characteristics are dropping in tandem with stock prices, it’s often emotionally difficult to hold on, even if it makes sense to do so. Consequently, this article will address some of the issues and challenges associated with long-term buy-and-hold investing in cyclical or semi-cyclical dividend growth stocks. In addition to discussing how to deal with long-term investing in cyclical stocks, I will also provide my personal perspectives on whether it’s a rational idea or not.
As an aside, since I am a believer in long-term investing versus day trading or swing trading, it is my personal strategy of choice. However, I am not brash enough to suggest that trading strategies are wrong; instead, I’m simply suggesting that long-term buy-and-hold investing suits me and my temperament better. Therefore, this article is likely to make more sense to other like-minded long-term buy-and-hold investors. Moreover, there is a fundamental mindset that differentiates the prudent investor from the speculator/trader.
My associate, Eli Inkrot, a young investor who I believe is wise beyond his years, has a way of expressing this differentiation of mindset in a manner that I really admire. Instead of referring to it as a buy-and-hold strategy, Eli calls it “partnering with a wonderful business.” To my way of thinking, that simple phrase both elegantly and profoundly says it all. The owners of “wonderful businesses” are in it for the long haul. The notion of selling their wonderful business, especially on a whim or as a knee-jerk reaction to what might be happening in an often wacky world (stock market), is simply not part of their DNA.
The Commonly Held Definition of a ‘Cyclical Stock’
Moreover, in order for this article to make sense, I believe it’s imperative that we start by defining, as precisely as possible, exactly what a cyclical stock is. I feel this is both essential and important because, like many terms and concepts glibly thrown about within the financial services industry, there is often a wide lack of precision regarding the true meaning of the term. In my humble opinion, the term “cyclical stock” is one of those quite often loosely utilized and/or imprecisely defined terms.
For example, Investopedia defines a cyclical stock as follows:
“An equity security whose price is affected by the ups and downs in the overall economy. Cyclical stocks typically relate to companies that sell discretionary items that consumers can afford to buy more of in a booming economy and will cut back on during a recession. Contrast cyclical stocks with counter-cyclical stocks, which tend to move in the opposite direction from the overall economy, and with consumer staples, which people continue to demand even during a downturn.”
Frankly, although I believe that this definition does provide some insight into the general characteristics of a cyclical stock, I contend, as I will explain in greater detail later, that it lacks true precision. Perhaps that is part of the reason why Investopedia then goes on to attempt to explain a cyclical stock more fully as follows:
“Cyclical stocks rise and fall with the business cycle. This seeming predictability in the movement of these stock’s prices leads some investors to try to time the market by buying these stocks at the low point in the business cycle and selling them at the high point. Examples of companies whose stocks are cyclical include car manufacturers, airlines, furniture retailers, clothing stores, hotels and restaurants. When the economy is doing well, people can afford to buy new cars, upgrade their home furnishings, go shopping and travel. When the economy is doing poorly, these discretionary expenses are some of the first things consumers will cut. If a recession is bad enough, cyclical stocks can become completely worthless as companies go out of business.”
The above expanded discussion of cyclical stocks does attempt to provide a deeper insight into the nature of a cyclical stock. However, although I agree with much of how the above commentary denotes the general characteristics of a cyclical stock, like many other financial terms, I believe it offers too general of an explanation. Moreover, I think the above discussion referring to some investors trying to time the market, is also overly-simplistic.
I especially have a problem with the phrase “seeming predictability in the movement of the stock’s prices.” First of all, I don’t think there is predictability in the stock price movements of any company, and secondly, cyclicality to my way of thinking is more about short periods of time when earnings are dropping. In other words, the so-called business cycles are periods of time when business temporarily becomes weak, and stock price follows these weak business results. Stated more precisely, cyclicality is more about profits, than prices.
With the above discussion in mind, I would now like to offer my own personal definition of what a cyclical stock is to me. Instead of thinking in broad terms such as restaurant stocks are cyclical, I prefer to base my judgments on the specific or individual company or business that I am examining. For example, if a company has a steady history of increasing its earnings each year, I would not think of it as a cyclical stock merely because it operates in a broad category that is considered cyclical. In other words, I will base my judgment about what kind of a stock a given company is, based on its specific operating history.
For example, according to the explanation