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Earnings Rising? Sell These Stocks!

By John Rosevear - Updated Apr 6, 2017 at 1:35PM

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The strange science of cyclical investing.

Way back in the economic panic of March 2009, after some very public hemming and hawing, I bought a position in Ford (NYSE: F). As it happened, like a number of other Fools, I did so within a few days of the stock's low point. If you've paid any attention to Ford's amazing turnaround over the last year, you know that turned out to be a good move.

"That was a great value play," someone said to me recently -- and I had to correct them. A green-eyeshade look at Ford's intrinsic value in March of last year probably would have come up with a negative number. It was overpriced from a value perspective, even at $2 a share. Even at less than that, Benjamin Graham would not have smiled.

So why'd I buy it? Not because I'm some sort of super investing genius. I'm not. But after years of buying and selling auto stocks, I knew what I'd found. To me, Ford wasn't a value opportunity; it was a cyclical one.

A value investor might have concluded that $2 was a ridiculous price for a company that was nearly worthless on paper. In fact, many value investors who looked at Ford came to exactly that conclusion, seeking opportunities elsewhere. But some cyclical investors believed that $2 was a steal for a company that was very likely to bounce in a big way along with the economy -- assuming the company survived.

Sounds kind of backward, doesn't it? Welcome to the world of cyclical investing.

The ups and downs of cyclical stocks
What makes consumer-staples companies like PepsiCo (NYSE: PEP) great to hold during economic downturns? Simple -- people don't stop buying Mountain Dew when the economy goes south. They don't stop using banking services, either, or buying coffee, or shopping at Wal-Mart (NYSE: WMT).

PepsiCo and Wal-Mart and others like them are the kind of stocks one can -- and arguably should -- buy and hold for years. With moderate, steady growth year-in and year-out, and dividends that can be profitably reinvested, they make a great cornerstone for nearly any long-haul portfolio.

Cyclical stocks do not. They rise (sometimes sharply) and fall (often steeply) with the economy. Think of big industrial companies -- not just automakers like Ford and Toyota (NYSE: TM), but also chemical producers like Dow (NYSE: DOW) and DuPont (NYSE: DD), or paper suppliers like International Paper (NYSE: IP). These nuts-and-bolts companies do well when the economy's strong, and retreat -- but are big enough not to fail (usually) -- when it's weak.

The long-term charts of these companies tend to look like surf -- oscillating up and down within a range, sometimes trending gradually higher, sometimes not. Look at a 10-year chart of Dow Chemical, for instance. You'll see a huge dip early last year -- a supermassive cyclical bottom, I'd argue -- but before that, it's kind of a series of arches. There's a low in 2000, a low in 2003, a higher low in 2006, a whopper of a low in 2009, and then an upward trend since.

That cyclicality makes these stocks intriguing buys in range-bound markets. It's clear as day in retrospect, but those lows were the times to buy. And the highs -- which, take note, are less clearly defined -- were good times to sell and look for better opportunities.

But that's in retrospect. How can we spot them in time to take advantage of them?

The price-to-earnings trick
One useful guide to finding your way with cyclical stocks is to follow the price-to-earnings ratio -- but not in the way that a value investor would. Value investing is the art of finding stocks that are underpriced relative to their earnings. Thus, value investors have traditionally sought out stocks with low P/E ratios.

Cyclical investors, on the other hand, will seek high P/E ratios. Remember that these are boom-and-bust stocks. The earnings go up, and then the earnings go down -- sometimes way down, as with Ford last year.

What was Ford's P/E when I looked at it last year? With big losses, the P/E was technically negative. That's an extreme example, but often, you'll just see minuscule earnings yielding huge P/Es. (A more refined approach might employ a price-to-sales ratio, but you get the idea.) This trick works because most of these stocks won't fall to zero (unless they go bankrupt), and most of them won't go to the moon, either. The prices will make less dramatic swings than their earnings.

That tendency makes the P/E a useful when-to-sell indicator, too. At some point, a cyclical stock's earnings will typically start to get ahead of its price, causing the P/E to drop. When the economy seems to be in great shape, and Ford is earning money hand over fist, I might look to sell. Again, that seems like backwards thinking, but it's how companies like these tend to work.

Riding the cycle to profits
If you keep a reasonably close eye on the stocks you own (and you should), cyclicals can be a relatively predictable way to make good money -- once you get the hang of the cycles affecting the stocks you own. Like any investment -- but moreso than with some others -- knowing your cyclical holdings and following them closely is critical to success.

Could investing in big companies be a bad idea? Anand Chokkavelu explains why dividends are dumb.

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Fool contributor John Rosevear owns shares of Ford. Wal-Mart is a Motley Fool Inside Value pick. Ford is a Motley Fool Stock Advisor choice. Motley Fool Options has recommended a diagonal call position on PepsiCo, which is a Motley Fool Income Investor recommendation. You can try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Wal-Mart Stores, Inc. Stock Quote
Wal-Mart Stores, Inc.
WMT
$139.52 (0.11%) $0.15
Ford Motor Company Stock Quote
Ford Motor Company
F
$16.03 (-2.44%) $0.40
Toyota Motor Corporation Stock Quote
Toyota Motor Corporation
TM
$160.77 (0.85%) $1.35
Pepsico, Inc. Stock Quote
Pepsico, Inc.
PEP
$180.22 (-0.06%) $0.10
E. I. du Pont de Nemours and Company Stock Quote
E. I. du Pont de Nemours and Company
DD
DuPont de Nemours, Inc. Stock Quote
DuPont de Nemours, Inc.
DOW
International Paper Company Stock Quote
International Paper Company
IP
$44.40 (-1.29%) $0.58

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