With the market getting beaten up in anticipation of a possible recession, it would be criminal for us Fools to ignore the distinction between cyclical and non-cyclical companies.
A salt and battery
While I'd be hard-pressed to precisely quantify their characteristics, cyclicals are the companies most sensitive to economic cycles, and they're not particularly conducive to a long-term buy-and-hold investment strategy. They're challenging to value and nearly impossible to bottom-fish.
To explore this theme further, I've chosen a salt miner and an industrial battery maker, both of which recently reported excellent results. These companies offer indispensable products, which would appear to cushion the companies from a spending slowdown. As we'll see, spotting cyclicality isn't always that simple.
A stock that won't get licked
Compass Minerals
My main takeaways from Compass' annual report filed with the SEC are that its salt business offers:
- stable demand and cash flows across economic cycles
- low-cost, high-grade mines with long reserve lives, and
- the ability to steadily raise prices over time
These factors add up to a very attractive base business and make me pretty comfortable with an otherwise debilitating amount of debt, which was piled onto Compass as part of its separation from Mosaic.
Now, you may be familiar with the latter company as one of the freakishly fast-growing fertilizer foursome, including Potash
Now, if you believe that a fundamental shift has occurred in global agriculture, you might conclude that the market for fertilizer has come untethered from cyclicality. The companies in the space are certainly valued that way, with Potash and Mosaic both valued at around 24 times EBITDA. Note, however, that Compass makes no such claim in its filings with the Securities and Exchange Commission. Gone are the salt-related claims of steady demand and decades-long pricing power.
The fertilizer segment, having recently raised SOP prices by stunning amounts, looks to be invincible today, but I have my doubts that this is a sustainable trend. Fertilizer froth appears to be overwhelming a nice and boring countercyclical base business.
Don't get too charged up, now
Batteries, like salt, are another ubiquitous product. EnerSys
For that reason, when an important end-use sector turns down, EnerSys feels the pinch. An example is the ebullient build-out of telecommunication systems, which require battery reserve power. When that capital spending dried up, so did EnerSys' sales.
Not only do Enersys' customers face cyclicality, but EnerSys itself has to contend with volatile prices for its own raw materials, such as lead, steel, and copper. Spot lead prices, for example, have roughly doubled over the past year.
Once you factor in EnerSys' lack of pricing power due to fierce competition, it becomes clear that the company can really be hurt in several different ways. Demand can fall, material costs can cut into profits, and low-cost competitors can undercut the firm on price. There's also a legion of material science companies and well-funded start-ups seeking next-generation stored energy solutions, but that's a longer-term threat.
Everything is going EnerSys' way at the moment, but this is exactly the sort of stock I would not want to be holding when the music stops.
Related Foolishness:
- Low P/E ratio on a cyclical stock? Better get out of the way.
- Here's another way to recession-proof your portfolio.
- John Mauldin knows a thing or two about the business cycle.
