The Good, the Bad, and the Business Cycle

Last week, I suggested that Rule Maker contenders be kept out of the ring until they have seen a complete business cycle. Boy, did I open up a can of worms with that one. Business cycles are about as easy to nail down as a grasshopper on amphetamines.

According to the National Bureau of Economic Research (NBER), a private, not-for-profit research institute in Cambridge, MA, the United States is on its tenth business cycle since 1945. Excluding the cycle we are in now, which is 123 months long and still going, the post-World War II era cycles have averaged 61 months. Pulling out my whiz-bang HP 12C because I definitely don't have enough fingers and toes, I see that 61 months is one month longer than five years.

We'll get into the five years in a second, but first let's look at the length of "expansions" versus "contractions." Postwar expansions have averaged 43 months while contractions averaged a mere eight months. If a recession is only two consecutive quarters -- six months -- of declining GDP, I'd say we're doing pretty good. Unlike me, as our country ages, its hangovers are getting shorter. What's the elixir, you ask? Got me, but it looks like proof that our economic watchdogs are getting better at their jobs.

So, does five years a business cycle make? I don't know, but before we buy the next Rule Maker, we need to be able to answer the question, "Has this company seen good and bad times in its current incarnation?" with a resounding "yes."

The answer to that question, for me, regarding Yahoo! is "no." For the same reasons I hesitated over that presidential ballot last November, I am weary of our Yahoo! (Nasdaq: YHOO) investment. Sure, George W. accomplished a few things in Texas, but he was only there for five years. Even more worrisome was that he'd only served five years in political office. That's less time than it takes to become a doctor! Does it take less time to learn how to be president than it does to become a doctor? Now, I'm the last person to argue for career politicians at the helm, but five years -- that hardly seems like enough time to qualify as battle-tested.

Yahoo! falls into the untested category because it never saw a down cycle. The Internet war was just beginning when we bought it and Yahoo! hadn't even been issued its fatigues. So what is battle-tested for a company?

Referring back to the NBER data, we see that the postwar cycles have varied from 28 months to our current run of 123 months. Macroeconomic cycles vary in length and so do industry-specific cycles. Rather than assign an arbitrary five-year time frame as a rule-of-thumb measure for a company's business cycle, we should gauge each company by historical measures and make educated guesses about its future. Again, back to the art of investing. Educated guesses require some sort of reference point, and that's where the business cycle comes in to play.

How does this apply to our current holdings? Intel (Nasdaq: INTC) lives and dies by semiconductor inventory cycles, which are brought on by supply and demand issues dictated by business spending, production capacity, and a myriad of other factors. Intel has weathered a number of peaks and valleys over the last decade. It should be evaluated by looking at its performance through a complete inventory correction.

As Rich pointed out yesterday, Cisco's (Nasdaq: CSCO) two-year performance -- financial performance, that is -- is all over the map. Last quarter, Cisco reported a gross margin of 6.9%. A year ago, it was 64.5%. Judging Cisco on last quarter's performance is simply not an "accurate profile of Cisco's financial characteristics." Finding a middle ground is obviously necessary to look at Cisco going forward.

Microsoft (Nasdaq: MSFT) operates on a software upgrade cycle that is partially dictated by hardware upgrades, which, in turn, is significantly influenced by technological advancements. Yet, Microsoft also has an inordinate amount of control (it's a Bill Gates thing) over its business cycle. Since it has little competition in the operating system and office suite arenas, Microsoft can release new software at its own pace. In all likelihood, the new releases are based more on financial goals than customer needs.

The last few years have provided insight into how Microsoft will fare in rough seas. Growth rates have slowed and operating margins have contracted, but the Redmond behemoth has more cash, free cash flow margins still near 50%, and some very promising new initiatives like Dot.Net, HailStorm, and the X-Box. Anyone worried that Microsoft can't weather the storm?

Financial companies like American Express (NYSE: AXP) are slaves to interest rates. Yet, during 1999 and 2000 when the Federal Open Market Committee (FOMC) upped the fed funds rate six times by a total of 150 basis points, AmEx still grew revenues and earnings per share at a comfortable clip. That's a good test of the company's longevity.

Drug company holdings Johnson & Johnson (NYSE: JNJ), Pfizer (NYSE: PFE), and Schering-Plough (NYSE: SGP) have business models tied to so many different variables it's mind-boggling. An aging population may be working for them, but there is no guarantee that the next miracle drug will be discovered even though they spend billions in the lab. Yet, all three companies have proven time and time again that they can deliver those drugs.

Last year, J&J announced that the revenue from its blockbuster heartburn drug Propulsid would drop from $950 million to $250 million after it was linked with more then 80 deaths. But aside from a hiccup in the stock price, the company is relatively unscathed. Combine Propulsid troubles with the '80s Tylenol scare and you've got some serious battle scars. (For more on how to choose investments in resilient companies, check out the preview for our new online seminar.)

Now all we need to do is develop a complex mathematical formula that takes into account several dozen leading, coincident, and lagging economic statistics, combine them with industry- and company-specific data, divide by pi, and add three. Seriously, what we need to do is exactly what I've just done. Run through the factors that influence the business models of our investments, while making sure that we evaluate financial performance through thick and thin.

Fool on.

Todd Lebor has no fear of water on the right anymore. At the time of publication, he owned shares in Cisco, Intel, Microsoft, and Pfizer. Todd's other holdings can be found online, along with the Fool's complete disclosure policy.