“I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future”  – Howard Marks, The Most Important Thing

Analyzing a cyclical company presents a special set of challenges for the equity analyst. The market generally underestimates the role of the cycle, and this can result in wild swings in shares of cyclical stocks. For the smart analyst, this can create wonderful an opportunity. But to take advantage requires a robust framework to understand and value these companies. Like most things in investment, it’s difficult to get right. And like most things in investment, that doesn’t mean we shouldn’t try.

How Consensus Fails…And How to Take Advantage

As we covered in a blog post earlier this month, consensus usually gets it wrong. It gets it particularly wrong when it comes to cyclical companies. McKinsey carried out an analysis of 36 cyclical companies from 1985 to 1997, comparing consensus forecasts to actual numbers. The results showed very poor foresight on the part of analysts.

“The consensus forecasts do not predict the earnings cycle at all. In fact, except for the next year forecasts in the years following the trough, the earnings per share are forecast to follow an upward-sloping path with no future variation. You might say that the forecast does not even acknowledge the existence of a cycle” Valuation – Measuring and Managing the Value of Companies, McKinsey

 Of course where consensus gets it wrong, this sets the stage for a mispricing in the market. Again from Howard Marks:

“In investing, as in life, there are very few sure things… however, there are two concepts we can hold to with confidence:

• Rule number one: most things will prove to be cyclical.
• Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule one”