Buy low, sell high. Everyone knows it, but can anyone do it? The late financier and government advisor Bernard Baruch once said, "Don't try to buy at the bottom and sell at the top. It can't be done except by liars." But people try all the time, and I believe there's actually an honest buck or two to be made by those who do it right.
Wait a minute. Isn't timing the market a violation of principles that cut to the core of all things Foolish? Generally speaking, yes. But I'm not talking about trying to guess the market's fads and fashions. I'm talking about buying stocks -- cyclicals, they're called -- that tend to track the performance of the overall economy.
Cyclicals defined
I see a raised hand in the back. You, sir, in the shiny bowler hat. Could you repeat your question? "What are cyclicals?" you ask. Let me give you a brief introduction.
Over the course of years, good companies' prices tend to rise. Coca-Cola (NYSE:KO), General Electric (NYSE:GE), Starbucks (NASDAQ:SBUX), and Wal-Mart (NYSE:WMT) can be counted in this category. They sell what everyone wants or needs all the time. These are the ones where people say, "If you'd invested $10,000 in this company way back when, you'd have $1,000,000 today." But there are some companies with earnings -- and stock prices, usually -- that rise and fall in sync with the state of the economy as a whole. These are the cyclicals.
Cyclicals tend to be the real nuts-and-bolts companies of an economy. Think heavy industry and durable goods: metals, automobiles, chemicals, and paper producers. Phelps Dodge (NYSE:PD), General Motors (NYSE:GM) or Ford (NSYE: F), Ferro (NYSE:FOE), and Boise Cascade (NYSE:BCC) are some familiar examples. When things go well, they sell lots of their products and make a nice profit. When things don't go well, buyers aren't having any. Who wants to buy a new car when there's a chance of being laid off? But when the economy turns around again, watch out.
Investing strategy
Just as cyclicals' earnings go up and down with the economy, so do their stock prices, although to different degrees than earnings. And this brings us back to the buy-low, sell-high maxim. For a given stock, how do you know when it is time to get in and when to get out? Well, there's no definitive answer, of course. But as you might guess, a blind long-term buy-and-hold strategy might not work too well with these guys.
One counterintuitive school of thought suggests buying cyclicals when their P/E ratios are high -- a downturn-induced scenario that could arise if a stock's earnings fall proportionately more than its price. The idea is that once earnings go up, stock prices should rise, too.
But cyclicals don't tend to be monster-growth companies, price-wise. In a reversal of the above, earnings will, at some point, rise proportionately more than price. The resulting low P/Es (low relative to historical norms for the company or industry) could spell a good time to sell.
Searching for clues
"What other clues are there?" the gentleman in the bowler hat asks. Basically, know the industry and know the economy. It's not possible to address macroeconomic issues here, but first and foremost, a bet on a cyclical is a bet on the economy.
Industry-wise, you could start with something as simple as studying advertisements. When auto companies are advertising 0% interest and $10,000 cash back (OK, maybe not that much, but I can dream, can't I?), odds are that sales and earnings are sluggish.
Don't be lured into thinking that every company whose earnings fall with the economy is fair game for bottom fishing. A hard fall will leave some companies down for the count.
Ask yourself a few questions first. Is the company sound and likely to last through the downturn? Does it have the balance sheet resources (like cash) to ride out a poor earnings cycle? And what about management? Has it endured bad times before? What did the company do last time? During the good times, did it preparing for the next low period? Or did it make aggressive projections right up until things went south?
Evaluating management can be tough. While not every company is as forthcoming as Expeditors International (NASDAQ:EXPD) in statements to shareholders, it's often possible to get a feel for how a team operates, which counts for something at least.
Valuation
Finally, what about valuation? Briefly, any extrapolations based on historical trends should look at those trends going many years back, for obvious reasons: Recent earnings could be swayed by recent cycles. Benjamin Graham recommended using the average for the past 10 years. Whatever period you choose, try to incorporate at least a full cycle.
Cyclical stocks are certainly not for everyone. If it makes you nervous to buy a company with negative or near-zero earnings, stay clear. However, if you have the fortitude to buy stocks at what appears to be the depths of a recession -- and the fortitude to hold faith that the economy will improve -- you might consider cyclicals. They often lead the charge out of a recession, and if you've got the discipline to sell just when things look their rosiest, you could do quite well.
Just don't forget their nature, though. Peter Lynch wrote, "Cyclicals are like blackjack: Stay in the game too long, and it's bound to take back all your profit."
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Fool contributor Jim Mueller (gebinr in the boards) likes to read Expeditors International's 8-K statements, but he owns shares in just Ford and Coca-Cola. As always, the Fool has a disclosure policy .
