Cyclical stocks are often very frustrating to own as the big gains of yesteryear suddenly turn into equally epic losses at the drop of a hat. But if you know your cycle patterns, you can turn that baffling sequence upside down and make some real money.
We asked three of The Fool's top cyclical investors to share some of their best ideas in this space. Read on to see how they came up with Micron Technology (NASDAQ:MU), First Solar (NASDAQ:FSLR), and Main Street Capital (NYSE:MAIN).
A highly levered bet on small businesses
Jordan Wathen (Main Street Capital): I wouldn't touch the stock at today's sky-high price, but there will be a time to load the boat with shares of this high yielder. As a business-development company, Main Street Capital uses leverage to make corporate loans and equity investments in businesses that are too small for Wall Street and deemed too risky for banks. The loans typically yield 10% or more, indicative of the risk that comes with them.
Main Street Capital has a portfolio that's more exposed to losses in a downturn. Whereas the median company in its industry typically has a 90%/10% debt and equity investment mix, Main Street Capital has about three times more of its portfolio -- approximately 30% -- invested in equity positions.
At this point in the cycle, it's my view that these substantial equity investments offer more risk than opportunity. But at the bottom of the cycle, a portfolio chock-full of equity investments at depressed prices, with copious amounts of leverage on top, is exactly the kind of portfolio that will provide the highest returns.
Shares trade richly at a 70% premium to Main Street Capital's underlying book value, making them an easy pass at today's rich price. But if a downturn were to offer a lower multiple on a depressed level of book value, I'd be more than happy to make it part of my portfolio.
Micron Technology: A living definition of "cyclical"
Anders Bylund (Micron Technology): I can't think of a more cyclical industry than computer memory chips. That sector has very few pure-play investments left to choose among, because the last couple of boom-and-bust cycles led to lots of bankruptcies and a sweeping consolidation trend. Micron Technology survived all that, and the stock is currently riding the latest cyclical upswing with gusto.
Micron shares have gained more than 140% over the last 52 weeks. If you think that's the obvious end of the line, consider that the stock price increased more than sixfold in the 2012-2014 cycle. There's still room for improvement on top of the current surge.
And it's all based on improving business results. In the recently reported third quarter of 2017, Micron's top-line sales nearly doubled year over year, while the bottom line swung from an $0.08 net loss per share to $1.62 of positive earnings per share. Memory chip prices have not only stabilized, but posted actual growth in recent quarters, driven by disciplined manufacturing volumes among the four largest suppliers. That select handful of market leaders includes Micron, thanks to a couple of opportunistic buyouts at rock-bottom prices during the consolidation phase I mentioned earlier.
Micron and its small group of serious rivals could very well lose that discipline and start another brutal price war someday. If that happens, I would recommend keeping an eye on the situation and picking up some Micron shares when chip prices start to firm up again. The other players have too many other balls in the air to keep the price wars going forever, so the next market meltdown should come with an expiration date. Micron has been to that rodeo before, and has always come through with flying colors.
I wouldn't even mind adding to my existing Micron position right now, actually. The stock is trading at just five times forward earnings as the company generated $5.9 billion of operating cash flows from $17.4 billion in trailing revenues. But if that's still too rich for you, keep this stock in mind the next time memory-chip prices settle down after a savage price war.
It could happen, after all.
Here comes the sun?
Keith Noonan (First Solar): The solar-panel business has been hampered as a result of supply glut depressing prices, but there are signs it could be ready for a rebound. First Solar's stock has already regained some ground following first-quarter results that beat analyst expectations and the emergence of a sunnier market outlook, and it looks like there could be more upside with the industry still near the bottom of a cycle.
The company's forward price-to-earnings (P/E) ratio is at a high point -- usually, a characteristic that should be avoided when picking stocks, but one that actually tends to be desirable with cyclicals because it can point to the bottom of a cycle. However, even with its lofty earnings multiple, the company trades at a price-to-book value of less than 0.8 -- and a price-to-book value of less than one often is a good indicator that a stock is undervalued.
First Solar also has a great balance sheet to fall back on if things take a turn for the worse, or the company should need to grow through acquisitions -- with roughly $2.1 billion in cash and short-term assets net of debt. Management expects that will shrink to between $1.4 billion and $1.6 billion by the end of the year as the company makes manufacturing upgrades, but that would still put its net cash position at between 34% and 39% of its current market capitalization.
With signs that the company could be significantly undervalued and big growth potential in the solar industry, First Solar looks like a worthwhile cyclical play.