Time for a Cyclical?

Investing in cyclicals is a proxy for the economy -- if you want to buy low and sell high, you should buy cyclicals at the low point in a recession and sell early into the recovering economy. Obviously, timing the economy is no easy task. But if you're willing to make a bet on the economy, it would behoove you to look at a well-run cyclical like Alcoa, a quality company that's suffering purely because of economic woes.

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By David Nierengarten
November 26, 2002

With the anemic economy and downright sickly stock market, investors' dreams naturally turn to� cyclicals?

Well, why not? Cyclical stocks, those stocks that deal in mature markets (I don't mean Geritol futures, either), are often overlooked by investors. Cyclicals are stocks that ride the wave of the business cycle, which is the track the economy takes from trough to expansion, stagnation, and back into recession.

Frequently, it can be hard to get a handle on cyclicals, as the best time to invest in them is near the low point of a recession, when many people want to jump out of the stock market. In fact, one "trick" to investing success with these stocks is to correctly deduce the direction of the economy and then sell when the recovery is humming along, as many times the cyclical stock becomes fully valued or overvalued at this point. 

There are two main types of cyclical stocks -- durable goods and basic materials. Durable good manufacturers track the economy and interest rates -- more people will buy a car when they have that well-paying job and interest rates are low. Basic materials stocks tend to track the price of the commodity that they sell, and that price is a function of supply and demand.

Recently, there has been no shortage in the supply of basic materials commodities such as oil, silver, copper or the like. The more relevant factor, then, is demand -- and demand for basic materials increases early in an economic recovery, increasing prices of these commodities. Of course, if prices go too high, inflation rises, the Federal Reserve increases interest rates, and the economy cools off (remember those days?). Hence the importance of selling a basic materials stock relatively early into the expansion phase of the business cycle. 

Now for the tricky part. Because a bad economy is especially harsh on these stocks, many of their numbers will look, well, quite bad. As the economy cycles from peak to trough, so will these companies' earnings -- swings of 90%-plus are not uncommon. My preference is to look at large, well-run cyclicals that have fallen on hard times because of the economy, not because of problems with the business. It is the nature of the stock market to react violently to the wide swings in these companies' earnings. However, as the market overreacts to negative earnings reports, the astute investor can find a bargain. 

One such company is Alcoa (NYSE: AA), the largest aluminum manufacturer in the world. Alcoa has been suffering from extremely weak global demand for aluminum, primarily due to the near-demise of the aerospace industry, one of the main consumers of aluminum. In fact, 23% of their sales in 2001 was from the transportation sector, combining aerospace and automobiles. Weakness in industrial construction and machinery (about 20% of their sales) has also hurt demand. 

Some promising trends should help Alcoa when the economy improves, even more than might be expected from a "normal" recovery. There is a long-term trend to greater aluminum incorporation in automobiles -- a 44% increase per car in aluminum use is expected in European cars by 2005. The European market accounted for 20% of Alcoa's sales in 2001. In the American market, SUVs use more aluminum than passenger cars, and although their sales have leveled off recently, they represent a large market that was not present a decade ago. Also, despite the volatility of the airline industry, there has been growth in the sales of smaller jets and airplanes.  

A build-up of supply has also lowered aluminum prices to below $0.60/lb, greater than a 10% decline just this year. Naturally, this has squeezed Alcoa's earnings, and they have dropped from a high of $1.81 per share in 2000 to an estimated $1.00 per share this year. Going forward, though, earnings should be improved by the completion of a $1.1 billion restructuring program. In addition, the company is on track to pare another $1 billion from expenses by the end of next year.

But as Fools everywhere know, earnings aren't everything. Turning to Alcoa's balance sheet, we find that over the past two years, cash has increased 45%, receivables have decreased 24%, and inventory has decreased 12% (with sales down 7.5%). One number to keep an eye on, however, is their debt level, which has jumped from $2.6 billion in 1999 to almost $8 billion this year, giving a debt-to-equity ratio of 0.76.

On the cash flow statement, we find that capital expenditures for plants and equipment are under control, and have been for a decade, growing an average of 4% per annum (compared to sales growth of 9%) since 1992. With aluminum supply already in abundance, Alcoa doesn't need new capacity, but rather needs to optimize its existing capacity. In this regard, management's goal is to increase return on capital to the top quintile of the S&P 500 by improving plant efficiency.

All told, Alcoa's operations show signs of healthy management during an economic downturn, which should allow the company to deliver strong earnings growth in a recovery. As for what kind of stock performance a recovery might produce, let's take a look at how Alcoa did during the last recession and recovery.

The last recession in the early 1990s saw Alcoa's earnings drop from $1.33 per share in 1989 to a bottom of $0.10 per share by 1993. Assuming an investor thought that the recovery was beginning in 1992, and invested in Alcoa at an average price of $8.68 per share, she would have been rewarded by a total gain of 50.1% over the next three years. I use the next three years because typically you want to sell early into the recovery, and after three years, the stock price had begun to outpace increases in book value (20%) and sales (28%). 

Alcoa's gain of 50.1% from 1992 to 1995 is a 14.5% average annual gain over the period.  This return outpaced the S&P 500, which returned just under 40%, or 11.8% annually, over the same period. However, if you prefer the Buffett holding time of "forever," Alcoa's shares have continued to outpace the S&P for the past 10 years.  That's why a chance to purchase a best-of-class cyclical at a favorable point in the business cycle should not be overlooked.

As the business cycle bottoms out and moves inexorably to recovery, you might want to look into well-managed cyclical stocks like Alcoa. Additionally, you should be ready to sell the stock as the recovery matures, especially if the price moves faster than the underlying fundamentals or if management begins to lose focus. 

David Nierengarten (davidMN) is a long-time Fool Community member. Right now, you can join the crowd free for 30 days, or read our always entertaining Fool editorial disclosure policy.