Cycles Lead to Buying Opportunities

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When legendary investor Bernard Baruch was asked to describe the stock market, he replied that he was sure of one thing: "It will fluctuate." Baruch's remark is the only bit of certainty I know regarding the stock market, and it's no less true for the various industries that make up the business environment.

Basic economics
All industries and businesses follow the same basic laws of supply and demand. This concept has never changed and never will, and the cycle is quite clear.

During periods of high demand, high capacity utilization, and increasing operating margins, businesses begin implementing steps to meet the demand. The result usually includes new plant investment, increased product pricing, and increased production -- until supply exceeds demand. Then prices decline, less capacity gets used, and margins shrink. This period continues until -- you guessed it -- the available supply is outstripped by demand, at which point the cycle starts all over again.

For sale by owner
The homebuilding industry, currently garnering the media spotlight, offers a near-perfect example of this cycle playing out. After the tech bubble (a cycle in itself), the economy became a low-interest-rate environment, making access to capital very easy and cheap. Demand for housing grew rapidly. First-time homebuyers found it more manageable to assume loans and newly minted real-estate speculators used the flow of cheap money to "flip" homes. Homebuilders responded by turning out more homes and acquiring land lots at a blistering pace. For years, all was well.

Of course, the clock has to strike midnight sometime. The increased housing production ultimately exceeded demand, and now homebuilders like NVR (NYSE: NVR), Toll (NYSE: TOL) and Pulte Homes (NYSE: PHM) command a fraction of the market values they enjoyed in rosier times. These are all excellent companies with fine management, but with supply exceeding demand, it's not difficult to see why these firms are being battered.

The farmer's turn
The same situation is playing out with just about anyone involved in agriculture these days, but with a far brighter picture for players in this industry. For years, supply outstripped demand. But now, thanks to several factors including demand for ethanol and the rise of the middle class in China, agriculture products are in great demand. This boon has also created unbelievable profits for fertilizer companies. Shareholders in Monsanto (NYSE: MON), Mosaic (NYSE: MOS), and CF Industries (NYSE: CF) are reaping amazing harvests right now.

The key takeaway
An old proverb says "What has risen shall one day fall, and what is fallen shall again rise." Should investors concentrate their efforts on trying to time such cycles? Not at all, Fools -- that's a sucker's game. However, I do think that it's exceedingly important to understand the industries you're invested in, to reduce the chance that you'll make your investments at inopportune times. As investors, we are attempting to buy low and sell high, but this should not be confused with attempting to buy at the bottom and sell at the top. Buying at the bottom and selling at the top is an element of good fortune that will periodically come when investors focus on buying underpriced businesses and selling overpriced ones.

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