How to find bombed out consumer cyclical shares in a downturn (that might recover quickly in an upturn)
A contrarian approach to buying unloved cyclical shares in anticipation of a future market recovery
Strategy brief
Stormy economic conditions can be bad news for companies in consumer cyclical industries like retail, construction, and travel and leisure. Firms that operate in these industries do well when consumers are confident but often suffer when it looks like household finances will come under pressure. In tough times, cyclical shares often sell off much harder than those in defensive industries.
This strategy takes a contrarian view. It aims to take advantage of the longer term economic cycle by finding consumer cyclical shares that have fallen in price (and may be out of favour) but remain good quality and are potentially well positioned to rebound when the economy recovers.
With this strategy the objective is to find:
Consumer cyclical shares that have fallen in price
Share prices that are cheaper than they have been over the medium term
Companies with signs of robust financial strength
Companies where profits are stable and even growing
Background
To understand why some industries (and the companies in them) are cyclical, it’s worth being familiar with the four main phases of the economic cycle: Expansion, Peak, Contraction (recession), and Trough.
These phases are well understood and generally measured by changes in a country’s gross domestic product (GDP) and employment rates, but their timing is hard to predict:
Companies that operate in defensive industries like healthcare, food production, household goods, beverages, tobacco and utilities tend to have a smoother ride through the cycle. While all industries can be impacted negatively by inflation, defensives generally hold up better through recessionary phases. They have the advantage of being must-haves in good times and bad.
But while defensive industries can be more dependable in bad times, they’re not as exciting or potentially profitable in good times. By contrast, sensitive and cyclical industry sectors are much more reliant on the state of the economy. So when the economy is in good health, they benefit the most.
One of the most familiar sectors in this area of the market is Consumer Cyclicals (also known as Consumer Discretionary). It contains a range of industries that all have at least some dependency on the economic outlook and consumer confidence.
Not all cyclical shares are influenced by the same external forces. In the Basic Materials sector, for example, mining companies can be affected by global macroeconomic trends that are quite separate from country economies. They can also be affected by the level of supply and demand for very specific metals and other extracted materials.
By contrast, shares in the Financial Services sector are very dependent on the state of the economy - both at home and abroad. In periods of expansion, banks benefit from increased lending and high consumer confidence. But in a contraction, recessionary forces can stifle new business and lead to higher levels of debt defaults.
Here are the most common industry groups that sit within the Consumer Cyclicals sector:
When to use this strategy
Because consumer cyclical shares are sensitive to the economic cycle, they can sell off heavily when the outlook is bleak. When the market detects an improvement in the economy, these shares can rebound quickly.
Judging the precise time at which a market turns from bearish to bullish, or when economic conditions are genuinely improving is difficult. This strategy assumes that there could be further near term pain for consumer cyclicals but that their valuations are more attractive and their financial quality is high, so they are more likely to re-rate in price as the outlook improves.
Strategy checklist
Searching for consumer cyclicals at lower prices with a record of profitability, financial efficiency and strength that are potentially better able to resist economic pressures, retain customers and recover quickly in an upturn.
1. Has the share price fallen and the valuation improved?
When shares sell off hard, it can drive down valuation measures like the price-to-earnings ratio (P/E) and price-to-book ratio (P/B). Valuation changes need to be considered on a share-by-share basis, but it’s important to think about how the valuation might have changed and what it says about the market view. Beware of very cheap shares, which can turn out to be value traps (they just keep getting cheaper).
What to look for:
Has the share price underperformed the market over the past 12 months?
Is the company’s current price-to-earnings (P/E) ratio less than its 5-year average P/E ratio? (For a longer-term view, use the Cyclically Adjusted PE Ratio (CAPE Ratio), which is based on the average inflation-adjusted earnings from the past 10 years (also known as the Shiller P/E)
Note! The P/E valuation is influenced by two factors: Share Price and Company Earnings.
If the share price falls, the P/E based on the company’s previous year’s earnings will fall as well, making the share look cheaper (you are buying those earnings for a cheaper price).
But the market is always anticipating the future. So when a share price falls, it’s often because the market is less convinced about the reliability of the company’s future (or forecast) earnings. This is why cyclicals are badly affected during economic turmoil.
Forecast P/E ratios are calculated using the consensus of analyst EPS forecasts. In turmoil, analysts can be slow to update their forecasts - so be wary. Precise valuations in a downturn can be difficult, which is why this strategy includes some useful ‘quality’ checks.
2. Is the company profitable - and are its profits growing?
Earnings-per-share (or net profits) growth is commonly used in strategies that aim to find fast-moving shares. But in the search for earnings resilience, it can be worth taking a broader view of a company’s past, present and future profits, as well as any surprises to the upside. That can provide a clearer picture of those companies that are performing well - and where the shares may re-rate as the economic outlook improves.
What to look for:
Was the company’s EPS growth positive last year?
Is the company’s EPS forecast to grow in the year ahead?
Note! It’s worth being sceptical of precise earnings (or profit) numbers. These figures can be manipulated by management (by making adjustments elsewhere) for various reasons. But even so, earnings are still the most common measure of profitability and progression - and looking at trends in earnings can be useful.
3. Are there signs that the company has a robustly profitable business that can withstand economic pressure?
There are all sorts of measures of profitability, but one useful guide to good quality firms is high profit margins. These can be a pointer to strong profitability and pricing power. Pricing power makes it easier for companies to absorb or pass on rising input costs or soak up lower demand without sacrificing profits too much.
Margins are something that tend to be best compared on an industry-by-industry basis. But generally speaking, double-digit margins can be a clue to higher quality companies.
What to look for:
Does the company have high margins compared to industry peers?
Are the company’s operating margins generally stable over the past five years?
Note! Three of the most common measures of profit margins are ‘gross’, ‘operating’ and ‘net’ - and different investors have different preferences. You can think about them like this:
Gross margin = Gross sales minus the direct cost of sales (the cost of making the product or service)
Operating margin = Gross sales minus direct and indirect costs (the cost of making the product or service plus business costs and admin)
Net margin = Gross sales minus all expenses (the cost of making the product or service plus business costs and admin plus interest and tax)
Different industries tend to have different average margins. A guide to good margins would be to start at 10%, with a preference for up to 20% and beyond.
4. Is the company good at using its capital to generate strong, consistent profits?
There are a few measures that can help detect just how efficient a business is at generating a return. One of those is Return on Capital Employed (ROCE), which can be a signpost to firms that are lean, well managed and adept at allocating their cash. ROCE looks at how much return a company gets from capital it ploughs back into itself - and it takes into account both debt and equity. A high ROCE over time can be an indicator of firms with strong and defensible brands and franchises that can be expanded profitably.
What to look for:
Does the company have a ROCE of more than 10%?
Does the company have a stable, and improving, ROCE over the past five years?
Strategy risks
Beware! Some cyclical industries can be badly affected in an economic downturn, and some companies may even go bust. There is also potential for shares to continue falling in price for longer than expected.
Remember that in recessionary phases, companies will invest less and cut costs in the face of depressed business activity and lower consumer spending. Recession and inflation don’t usually overlap, but when they do, there is a risk of stagflation, with recession compounded by rising input prices (for raw materials) as well as reduced demand from customers. In both cases, profit margins are at risk of being squeezed.
Strategy summary
Overall, consumer cyclical industries are particularly sensitive to economic conditions and shares in these industries can sell off sharply when the outlook is uncertain. But the economic cycle dictates that an upturn will follow as the economy corrects itself, and consumer cyclical firms can be some of the early beneficiaries.
While timing cycles is very difficult, this strategy takes a contrarian approach by looking for shares that have sold off and are out of favour. Their earnings forecast may or may not have been revised by analysts, but the point is that sentiment towards them has turned negative.
This strategy targets this sector, looking for firms where earnings are resilient and preferably growing and where some key quality indicators like profit margins and return on capital employed are both consistently high.
During phases of higher economic uncertainty, cyclical shares are always prone to further downside pressure. But for investors with longer term outlooks and an eye for future recovery, these industries could offer opportunities.