Cyclical and capital-intensive businesses

In simple terms

Some businesses earn fairly steady profits whatever the economy does: people buy toothpaste and medicines in good years and bad. Others see demand and prices rise and fall sharply. These are cyclical businesses. Their profits can triple in a boom and turn into losses in a slump.

Many cyclical businesses are also capital-intensive: they need large factories, mines, furnaces or kilns to produce anything. That combination, swinging demand and heavy fixed investment, makes their profits especially volatile and their valuation especially tricky.

What makes a business cyclical

Two kinds of cycle drive these businesses.

• Demand cycles. Customers can postpone purchases when times are hard. New cars, homes, machinery and construction projects are delayed in a slowdown, so the industries supplying them, such as autos, cement, steel and capital goods, feel it strongly.
• Supply cycles. When prices are high, producers build new capacity. Plants take years to build, so the new supply often arrives just as demand cools, pushing prices down. Commodity industries such as metals and chemicals often follow this pattern.

The result is a repeating pattern: rising prices and profits, heavy investment, oversupply, falling prices and losses, closures and cutbacks, then recovery.

Capital intensity

A business is capital-intensive when it needs a lot of plant and equipment for each rupee of revenue. A cement company may need several rupees of assets for every rupee of yearly sales; a software company may need very little.

Capital intensity has three consequences:

1. High fixed costs. Depreciation, interest and maintenance must be paid whether the plant runs full or half-empty. This creates operating leverage: profits rise fast when volumes grow and fall fast when they shrink.
2. Heavy reinvestment. Plants wear out and must be replaced, so a large share of profit goes back into capital expenditure just to stay in business.
3. Lower returns on capital unless the company has a cost or market advantage, because so much money is tied up in assets.

The peak-earnings trap

At the top of a cycle, a cyclical company's profit is unusually high. Its P/E ratio, price divided by earnings, therefore looks low, and the share can appear to be a bargain. In fact, the market may be pricing in a fall in profit that has not happened yet.

The opposite also happens: at the bottom of a cycle, profits are depressed, P/E ratios look very high or cannot be calculated, and the shares can be at their cheapest relative to what the company earns across a cycle.

Judging cyclical companies

Use normalised profit. Estimate what the company earns on average across a full cycle, using several years of history or the average margin applied to a normal level of sales. Value the business on that, not on this year's figure.

Check survival. In the bad years, a heavily indebted cyclical company may not survive to see the recovery. Look at debt, interest coverage and cash in the worst years of past cycles.

Watch capacity. Industry-wide capacity additions, announced in good times, are a warning that prices may fall when they come on stream.

Look at costs. In a commodity industry, the lowest-cost producers survive downturns and earn the most in upturns. A company's position on its industry's cost curve matters more than its brand.

Read management's capital spending. Companies that build aggressively at the peak and cut at the bottom tend to destroy value; those that invest steadily or counter-cyclically often do better.

Why it matters

Many of the biggest losses in investing come from buying cyclical companies at peak profits, when they look cheapest, and many of the best opportunities come from buying them in slumps, when they look most expensive. Understanding the cycle turns misleading ratios into useful ones and helps you avoid extrapolating a boom.

Limitations

Cycles are not regular: their length and depth vary, and a structural change, such as a permanent fall in demand, can look like a cyclical dip at first. Normalised profit is an estimate that depends on which years you include. And the timing of cycles is very hard to predict; recognising where you are is easier in hindsight.

Common mistakes

• Valuing a cyclical company on peak profit. A low P/E at the peak is a warning, not a bargain.
• Extrapolating recent growth. Rising profits in an upswing do not continue indefinitely.
• Ignoring the balance sheet. Debt that is comfortable at the peak can be dangerous in the slump.
• Mistaking a structural decline for a cyclical dip. Ask whether demand will really return.

Try it yourself

Choose a listed company in a cyclical industry such as cement, steel, autos or chemicals.

1. Collect its net profit for as many years as you can, ideally ten.
2. Mark the best and worst years and calculate the average.
3. Divide its current market capitalisation by its latest profit, then by its average profit. How different are the two multiples?
4. Note its debt in its worst year and whether it was able to pay interest comfortably.