A model to think about cyclicals – a Value Investor’s perspective

Let’s start off with a few quotes from some of the value investment greats.

 “Face up to two unpleasant facts: the future is never clear and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.” Warren Buffett

“The single greatest edge an investor can have is a long-term orientation.” Seth Klarman

"The best opportunities are usually found among things most others won't do." Howard Marks

“To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.” John Templeton

In this blog, I want to talk about a way to think about cyclical as a value investor. The above quotes pretty much sum things up – like uncertainty, have a long-term orientation, go where most others won’t, be skeptical. But, let’s also try drawing some specific conclusions – come up with a mental model to think about cyclical stocks.

Recently, I read a fantastic blog by the folks at The Value Perspective (http://www.thevalueperspective.co.uk/) – the team at Schroders who follow a value style in managing c£12bn of assets. I highly recommend their blog.

In one of their recent posts (http://www.thevalueperspective.co.uk/en/uk/the-value-perspective/blog/all-blogs/in-the-picture-ii/), I saw 3 pictures that I think sum up the way a value investor should think about cyclical's. As they say in their blog, a picture is worth at least two paragraphs:

Cycles

Source: http://www.thevalueperspective.co.uk/

As can be seen from the graph, cycles are recurring, fairly predictable, pattern of periodic fluctuations. They repeat themselves – typically every 5-7 years – in four stages – 1) expansion, 2) peak, 3) recession, and 4) recovery. Here is the important bit – nobody can really predict their timing; but, one can reasonably estimate in which stage of the cycle one stands today. It is important to note that having a good feel for which stage of the cycle we are in today is not the same as knowing what is going to happen tomorrow, or day after, or in a month, or year.

Cycles and market’s behavior

Source: http://www.thevalueperspective.co.uk/

Above is an ingenious way of picturing Market’s behavior during cycles. This is a great way to think about the Market for a value investor. Broadly, at the top of the cycle, the Market can only think of the good things that are going to happen- as implied by the positive skew; and, at the bottom of the cycle, the Market can only think of the bad things that are going to happen – as implied by the negative skew. This happens all the time – time after time. Just scan the news of late and you will find headlines like – “If China Killed Commodity Super Cycle, Fed Is About to Bury It”; and, scan the news from 5-7 years ago, and you will find that it’s all hunky-dory in the commodities world.

A Value Investor’s model for cycles

Source: http://www.thevalueperspective.co.uk/

The above picture sums up so much about value investing; if I have to sum up the key messages from the quotes at the beginning of this blog, this picture would do a nice job. Here are the key takeaways (paraphrased from The Value Perspective):

• longer time horizon allows us to see the cycle merely as points on the distribution curve around average profitability – i.e., a value investor doesn’t have a skewed outlook;
• by investing in businesses at the point of despair, when the wider market sees no chance of recovery, pushes the odds in favour, gets the forces of mean reversion on side; and,
• by investing when prices are low, gives us the best chance of superior long-term returns.

However, there are other risks that needs to be considered. The main ones being:

1. Is the decline really cyclical? Or, it this structural? – for example, is the commodity or the product likely to go permanently out of fashion or use.
2. Debt – If the business has very high level of debt, the equity holders risk being taken out during a prolonged downturn. This matters for a value investor, as he/she is in the game for the long-term, and debt threatens the long-term survival.
3. Operating leverage & break-even point – What is the gross profit margin? What is the proportion of fixed costs in the company’s cost structure? –gives an indication of earnings quality, and the company’s ability to sustain in a prolonged downturn.

Consider NMDC – India’s largest iron ore miner. The company has access to superior quality iron ore assets with reserve base of 1361 MT (~42 years at current production rate). It is 80% owned by the Government, with 20% free float. Its shares have fallen by more than a third this year. It has no debt on balance sheet; and enjoys very low costs - high level of mechanization and access to an inexpensive labour enables it to keep its costs at ~US$20/tonne (one of the lowest globally). Prices of iron ore have fallen significantly this year, and are currently at 10 year low ~US$38/tonne. Many miners are likely to go under – many don’t even break-even at this price, let alone make money. The next couple of years are not looking good for iron ore, and there is likely more pain to come. Most things you will read at present about iron ore, and the miners, will likely be negative. 

That said, Iron ore, the main raw material in steel manufacturing, is not going out of fashion. NMDC, with its strong balance sheet, and superior cost advantage, should be well placed to ride the low, and tap into the recovery when it comes. The commodity “super cycle” may be a thing of the past - iron ore prices are unlikely to touch the heights of 2010/11 - but the odds of them recovering to a more meaningful ~US$50-US$70/tonne in a few years are not bad. And when that happens, NMDC should gain handsomely. The key is - a long-term orientation & a contrarian mindset.