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February 15, 1999

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Subject: Re: Another Analysis
Author: joelsandberg

Cyclicality

Cyclical industries tend to be those which require large capital expenditures, and hence long lead times, to add production capacity.

The cycle goes something like this. As the market grows, industry eventually reaches its existing production capacity. Prices go up. Higher prices make capital investment for more capacity attractive. ALL THE PLAYERS simulaneously and independently decide to add capacity to capture market share and sell product at the higher prices. All of the market players now commit Billions of dollars for plant expansions. Two to five years down the road, when this capacity comes on line, there will be too much production capacity, prices fall, net income, ROE and margins go to heck and the stocks take a beating. The market grows, absorbs this excess capacity, and the cycle begins again.

"Because of the huge sums of money and long lead times needed to build the plants, companies are very reluctant to stop expansions once they start."

All the companies in the industry know about the additional capacity that its competitors are bringing on line. Why don't they back off on their commitments? Because of the huge sums of money and long lead times needed to build the plants, companies are very reluctant to stop expansions once they start. Your competitor is expanding in order to gain market share. And the actual size of the market several years down the road is uncertain. What would you do?

I work in the paper industry where the overcapacity phase of this cycle is in full bloom. But the pattern is repeated often in the automotive, chemicals, petroleum, semiconductor industries (but not the PC industry - there problem is one of low barriers to entry producing ever shrinking margins).

"Can growth be found in cyclical industries? Certainly. But it will be sinusoidal, with ups and downs that follow the industry."

A separate phenomenon is CONSUMER cyclicals, where the cyclicality is driven, not by cycles in production capacity, but by cycles in demand related to economic activity. These tend to be the discretionary purchases - electronics, etc.

Can growth be found in cyclical industries? Certainly. But it will be sinusoidal, with ups and downs that follow the industry.


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