Earnings Rising? Sell These Stocks!

Way back in the economic panic of March 2009, after some very public hemming and hawing, I bought a position in Ford (NYSE: F  ) . As it happened, like a number of other Fools, I did so within a few days of the stock's low point. If you've paid any attention to Ford's amazing turnaround over the last year, you know that turned out to be a good move.

"That was a great value play," someone said to me recently -- and I had to correct them. A green-eyeshade look at Ford's intrinsic value in March of last year probably would have come up with a negative number. It was overpriced from a value perspective, even at $2 a share. Even at less than that, Benjamin Graham would not have smiled.

So why'd I buy it? Not because I'm some sort of super investing genius. I'm not. But after years of buying and selling auto stocks, I knew what I'd found. To me, Ford wasn't a value opportunity; it was a cyclical one.

A value investor might have concluded that $2 was a ridiculous price for a company that was nearly worthless on paper. In fact, many value investors who looked at Ford came to exactly that conclusion, seeking opportunities elsewhere. But some cyclical investors believed that $2 was a steal for a company that was very likely to bounce in a big way along with the economy -- assuming the company survived.

Sounds kind of backward, doesn't it? Welcome to the world of cyclical investing.

The ups and downs of cyclical stocks
What makes consumer-staples companies like PepsiCo (NYSE: PEP  ) great to hold during economic downturns? Simple -- people don't stop buying Mountain Dew when the economy goes south. They don't stop using banking services, either, or buying coffee, or shopping at Wal-Mart (NYSE: WMT  ) .

PepsiCo and Wal-Mart and others like them are the kind of stocks one can -- and arguably should -- buy and hold for years. With moderate, steady growth year-in and year-out, and dividends that can be profitably reinvested, they make a great cornerstone for nearly any long-haul portfolio.

Cyclical stocks do not. They rise (sometimes sharply) and fall (often steeply) with the economy. Think of big industrial companies -- not just automakers like Ford and Toyota (NYSE: TM  ) , but also chemical producers like Dow (NYSE: DOW  ) and DuPont (NYSE: DD  ) , or paper suppliers like International Paper (NYSE: IP  ) . These nuts-and-bolts companies do well when the economy's strong, and retreat -- but are big enough not to fail (usually) -- when it's weak.

The long-term charts of these companies tend to look like surf -- oscillating up and down within a range, sometimes trending gradually higher, sometimes not. Look at a 10-year chart of Dow Chemical, for instance. You'll see a huge dip early last year -- a supermassive cyclical bottom, I'd argue -- but before that, it's kind of a series of arches. There's a low in 2000, a low in 2003, a higher low in 2006, a whopper of a low in 2009, and then an upward trend since.

That cyclicality makes these stocks intriguing buys in range-bound markets. It's clear as day in retrospect, but those lows were the times to buy. And the highs -- which, take note, are less clearly defined -- were good times to sell and look for better opportunities.

But that's in retrospect. How can we spot them in time to take advantage of them?

The price-to-earnings trick
One useful guide to finding your way with cyclical stocks is to follow the price-to-earnings ratio -- but not in the way that a value investor would. Value investing is the art of finding stocks that are underpriced relative to their earnings. Thus, value investors have traditionally sought out stocks with low P/E ratios.

Cyclical investors, on the other hand, will seek high P/E ratios. Remember that these are boom-and-bust stocks. The earnings go up, and then the earnings go down -- sometimes way down, as with Ford last year.

What was Ford's P/E when I looked at it last year? With big losses, the P/E was technically negative. That's an extreme example, but often, you'll just see minuscule earnings yielding huge P/Es. (A more refined approach might employ a price-to-sales ratio, but you get the idea.) This trick works because most of these stocks won't fall to zero (unless they go bankrupt), and most of them won't go to the moon, either. The prices will make less dramatic swings than their earnings.

That tendency makes the P/E a useful when-to-sell indicator, too. At some point, a cyclical stock's earnings will typically start to get ahead of its price, causing the P/E to drop. When the economy seems to be in great shape, and Ford is earning money hand over fist, I might look to sell. Again, that seems like backwards thinking, but it's how companies like these tend to work.

Riding the cycle to profits
If you keep a reasonably close eye on the stocks you own (and you should), cyclicals can be a relatively predictable way to make good money -- once you get the hang of the cycles affecting the stocks you own. Like any investment -- but moreso than with some others -- knowing your cyclical holdings and following them closely is critical to success.

Could investing in big companies be a bad idea? Anand Chokkavelu explains why dividends are dumb.

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Fool contributor John Rosevear owns shares of Ford. Wal-Mart is a Motley Fool Inside Value pick. Ford is a Motley Fool Stock Advisor choice. Motley Fool Options has recommended a diagonal call position on PepsiCo, which is a Motley Fool Income Investor recommendation. You can try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (35)

Comments from our Foolish Readers

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  • Report this Comment On April 05, 2010, at 12:54 PM, loki2009 wrote:

    Well - sorry about this because it's a decent comment, although a little ambiguous and slightly misguided - so I MAY have to disagree. Ford was not worth $2.00 a share on paper? Not sure what that means. If you mean the book value of Ford - then I would have to agree with you. However - on paper - there were a number of different ways to calculate the value of Ford. The most reliable though, in my opinion, was to calculate the economic value. You could not possibly build/develop Ford's plants and people for $5 Billion (2.5 billion shares * $2.00). In addition, because of Mulally's genius, you had a company that was likely to earn a couple billion in 2009, $8+ billion in 2010 and $12 billion in 2011.

    Those were my predictions - I am on record here, and many other places, providing the analysis and rationale for those numbers.

    So my position is - Ford was not just a cyclical play - it was the turn-around play of the century. Why - what did Ford have that GM and Chrysler did not? Two things - the genius of Mulally and a controlling shareholder whose entire family history was inextricably linked to the company.

    I said it all the way through the dark days and now through the sunny days. Many here ridiculed me and laughed. What say they now?

    Mark my words - Ford is on its way to $25 a share. Not someday - but within 2-3 years. Americans are once again falling in love with the car Henry built and will reward the incredible turnaround at Ford - not just financially - but in the very way they think, the attitude - throughout the organization. Every employee now believes they can build great cars. Such is the genius and foresight of Mulally. And kudos to Bill Ford for his relentless pursuit of the recruitment of this person for his CEO.

    Loki

  • Report this Comment On April 05, 2010, at 2:46 PM, madmilker wrote:

    Wal*Mart is the only sell....

  • Report this Comment On April 05, 2010, at 3:55 PM, TMFMarlowe wrote:

    Loki, what I meant is that Ford wasn't "worth" $2/share using a straight-up Ben-Graham-style value analysis. You and I knew better, and the point of the article was to explain how others can spot situations like that in the future.

    Thanks for reading.

    John Rosevear

  • Report this Comment On April 05, 2010, at 7:25 PM, SwampBull wrote:

    John,

    Thanks for the article, you bring up an intriguing point about mislabeling an intelligent speculation as an intelligent value investment.

    I would very much enjoy a follow-up article on how to determine the net-present-value per share. Would you use net current assets minus net long term debt/liabilities to determine book value, or some DCF calculations? Also, what was it about Ford that would make you pull the trigger against, say, Citi Group? I fall into the category whom you mentioned took a look at what they saw on Ford's balance sheet, and walked away. That being said, I caught the knife pointy side up (no cuts!) when it comes to Wells Fargo.

    Thanks for the article,

    Swamp

  • Report this Comment On April 05, 2010, at 8:22 PM, baldheadeddork wrote:

    Another good post on the auto business, John.

    I agree that Ford is a cyclical stock that had a meteor fall on it last year instead of a value investment, but don't overlook the dividend angle when making long-term plans for this stock.

    This industry traditionally pays dividends and Ford paid a quarterly dividend in every quarter but two from 1956-2006. If Ford can continue to pay down its debt and remain profitable, I think it is possible that they will restore the dividend at some point say, 3-5 years from now.

    That changes the way I'm looking at this stock. We bought last May for around $5.50 a share. Without any chance at a dividend (I'm lookin' at you, SIRI) then I think you're right that it would be a good idea to watch the valuation and sell when the P/E drops. But if the dividend returns at the average for 1996-2006 of $0.25 a quarter, that would give us a 20% yield, and a 50% yield for someone like you that got in at $2. That's a lot of protection from the price swings of a cyclical stock.

    Am I getting this totally wrong?

  • Report this Comment On April 06, 2010, at 8:20 AM, funfundvierzig wrote:

    For more than a decade, the long term trend of DuPont has been, down, down, down. Unlike the brilliantly led Ford Motor Company, DuPont has suffered from an embedded and mediocre management for years, with no imminent signs of a robust turn-around.

    DD touched its peak in 1998 at 84 and change on a much greater number of outstanding shares. Shrinkage seems to be the business paradigm for this demoralised old-line chemical conglomerate. ...funfun..

  • Report this Comment On April 06, 2010, at 11:06 AM, Aargon wrote:

    I still think you are leaving out the one metric that brought alot of us to buy Ford. They did not accept government bailout money. This is why alot of us were willing to bet they were going up while the others went down. In the long term the question comes up how they will deal with those old so called legacy costs that the ones accepting the bail outs have had thrown out.

  • Report this Comment On April 10, 2010, at 11:11 PM, xcrunner1732 wrote:

    I definately agree with Aargon. Sure I saw Ford as a terrific bounce-back play, which I bought at 1.81, but the deciding factor to actually buy Ford over the thousands of other stocks was the fact that they said 'thanks but no thanks' to the US government. I see a huge profit potential in Ford over the next 2-3 years at least. Ford has benefitted from the awesome leadership of CEO Mullay. Any reader of "How to Make Money in Stocks" by O'Neil will realize the upward potential for Ford. Ford has relatively new leadership, a terrific new engine, and their stock chart doesn't look too bad either.

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