Cyclical stocks tend to be reliable profit generators in a value investor’s portfolio. Cycles exaggerate the valuations because they cause uncertainty in the market. So arguably, value investing should work very well. In practice, it can be hard to identify the right investment candidates and pick the right time to invest.

We all know that value investing involves buying stocks at prices depressed below the intrinsic value. Cheaper the stock, better the purchase, as theoretically the potential returns (normalizing the price to value) are higher and the inherent risk of capital loss is lower (stock is already at distressed levels where investors have given up).

Most cycles in essential commodities are predictable.

Phase 1 – Growth and Investment: The business in an industry goes through a period of growth, managers become more confident and hire more employees, invest in assets and new projects and build new plants and increase capacity. There are new entrants in the industry as it grows with above average profits. The analysts build Discounted Cash Flow and other models that assume good earnings growth for the near future and a possible terminal growth rate thereafter (which is almost always a positive number). This results in higher multiples being assigned to the stocks in the industry than the historical average. Wall Street firms do a lot of business with these growing companies flush with profits and are therefore inclined to look upon them in a kind light. Investors pile in.

Phase 2 – Peaking: All the capacity expansion via new capital investments and new entrants in the industry finally reaches a point where it starts to exceed the market demand. The profit margins get squeezed as the marginal unit of production starts to sell at cost or below cost. The high cost and smaller economies producers start to exit the market. A few players may merge to improve their economies of scale or add in new line of businesses to support the company until the cycle in this line of business recovers. Wall Street starts getting disappointed many quarters running as the earnings come in lower than expected.