CYCLICALS-- When and Where to Bet?

We seem to be in a downward spiral in the context of Indian (and most of world markets for that matter) markets. Various sensex targets ranging from 12-14k have been projected and who knows might be achieved if things continue in the same vein in the absence of strong policy response from the govt and any change in the scenario in the world economy.

The question now is how best to utilise the circumstances to our advantage to maximise returns from this sharp market correction. The stocks that provide maximum returns on rebound are always the cyclicals which have been beaten down out of shape. And that I feel is a topic worth looking into.

The risk in investing in cyclicals is that one might bet too soon during the downmove and then get frustrated, seeing the stock bet on going down further from the buy price.

I think the trick lies in identifying companies which are going to survive the downturn/downmove and emerge stronger from the havoc as and when it ends.

Some attributes one should look for in such companies I feel are:

1). Company should have a very sound balance sheet preferably with low or no debt.

2). It should preferably be a market leader or no.2 in the sector it operates in.

3). It should be one of the lowest cost producers of the commodity/product it is engaged in.

4). Management integrity should be very sound.

5). High promoter holding and preferably no pledging.

6). Promoter buying from markets or company doing buybacks.

Obvious sectors that come to mind are infra sector, metals, plastics, polyfilms etc, real estate companies, companies punished out of proportion to its problems most commonly fccbs in the current market scenario, etc.

As and when the correction and the correction discussion progresses I would like to pitch in with my picks.

I think if one gets these rebound candidates right there could be 2-3 or 4 baggers within a very short time period. At least that is the observation I have made from looking at charts of various cyclicals/turnarounds during the previous corrections.

Comments/stock ideas most welcome.

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Hi Hitesh,

I’am new to the world of investing. I have a question concerning cyclicals.

Can we use Lynch’s strategy for identifying when cyclicals need to be bought ? He claims that we should buy cyclicals when their PE ratio is high and sell when PE ratio is lower. He says that is the best way to buy cyclicals. From my understanding, Lynch made the maximum money in cyclicals and he was a master at identifying cyclicals (Chrysler was his favourite).

I am not able to understand this and it is contradicting my understanding that stocks should be bought at low PE and sold at high PE if possible for maximum returns.

can you or any other senior please explain if this strategy applies in indian context (with an example)?

Regards,

Ananth

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hi anant,

What Lynch mentions essentially means that once the profits of so called cyclicals begin to tumble they will be out of proportion to the fall in stock price. Especially in automobiles there will usually be losses as fixed costs are going to remain same and sales vols begin to reduce. So company begins to post losses or very low profits and hence the EPS part of PE starts getting smaller and hence higher PE, even though prices might have corrected significantly.

But buying all high PE auto or any other cyclical stocks does not always work. One has to be tuned into the change of scenario by looking at first signs of improvement in business environment. Entering these stocks earlier might lead to a lot of suffering bcos the stocks of these sectors u own dont budge/or go down while markets may be making merry.

e.g If u look at the retail cement prices and monitor despatches of cement by various companies, one could easily make out that some amount of good times for cement as a sector might be forthcoming. ACC, ambuja cement, shree cem etc the bigger players have started moving up. The smaller guys will start their move later on in the game but the demand till then needs to sustain or increase.

hope this clears some of ur doubts.

regards

hitesh.

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Thanks for your explanation. You have understood Lynch’s strategy very well.

I was looking at the front line cement companies. The likes of gujarat ambuja, ultratech and ACC are at 52 week highs.

I was looking at Exide if it fits your description. It is market leader in automobile batteries and have a clean balance sheet. They have no debt, hence they cannot go bankrupt.

I don’t know much about the promoters though.

I was looking at the PE ratio if it fits Lynch’s strategy.

H2 FY12 EPS is almost 2.5. So, if I make projection of FY12 of EPS 5, the current price is near 120. That gives PE of 24 which is high. Doesn’t it fit Lynch’s strategy well ? Can one buy at these levels ?

regards,

Hit bhai,

do these cyclic companies satisfy your criteria

Bluestar

Esab India

Exide

Sintex

Crompton

Bharat Bijlee

Jain Irrigation

Biocon

Rallis India

Nesco

Cairn india

Jain Irrigation

Greaves cotton

Swaraj Engines

Gateway distripark

Alfa Laval

Mundra Port

GSPL

VST Tillers

Yes bank

Bajaj Electricals

Siemens

Thermax

Tata Steel

Bajaj Auto

Jindal saw

Jindal Steel

Balkrishna

Clariant Chemical

Prestige Estates

Savita Oil

Elgi equipment

Shree Cement

Jaiprakash associates

petronet LNG

Indraprashta gas

There is a difference between cyclical and seasonal business. Some of the above stocks will fall in the category of seasonal business and not cyclical. For ex, Bluestar, Nesco, Jain Irrigation, Rallis,etc are seasonal and not cyclical.

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Excellent topic Hitji, given the current market conditions.

2 names which come to my mind immediately are:

  1. Crompton Greaves

  2. IDFC

While crompton has been beaten down badly in the current turmoil, I think in the short to long term this is an excellent pick at the current valuations. Yes, I agree there is some overhang over the management problems earlier (jet purchase), but they seem to be getting their act together.

IDFC needs no introduction, solid company with good track record. I personally believe it is just a matter of time and this will start performing as the interest cycle turns and we see additional spending in the infra sector.

Please share your thoughts.

great thread Hitesh…short term cyclical basis, I am concentrating on these:-

1). Sintex - here I am probably the most convinced about their fccb

2). Shree Cement / JK Lakshmi Cement - rock bottom prices, am ready to wait for the upturn

Although not really cyclicals, but definitely worth mentioning here are the rate sensitives:-

Yes and Axis Bank

Shriram Transport Finance - interest rate and lifting of mining ban play

Nice thread Hiteshbhai!

I dont know how to play sugar sector but returns could be huge as and when cycle turns…

Could be played through Renuka Sugar, Balrampur Chini or Bajaj Hindustan… Any idea on sugar sector and which company is best to play?

Infra: 1) Engineers India - Very strong company. Should bounce back quickly once and when infra cycle turns.

  1. Sanghvi Movers

Hi vipul,

Yes engineers India with its excellent balance sheet and niche expertise in petchem and oil segment is a good bet for quick rebound.

Sanghvi Movers will need the capex cycle to get into full swing for best performance.

Regarding Sugar sector, I think Renuka till now remained the best bet but I think with the Brazilian acquisition they might have chewed more than they can digest. EID Parry with its holding in coromandel intl and presence in relatively (political) troublefree South India looks like a good bet as and when the cycle turns. But currently it seems that the govt controls are very stringent and hence might create problems in the shorter run.

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My 1 pick would be Voltas which satisfies all your conditions. A cyclical business which can give RoIC of 40%+ in good times with rock solid BS, best in class business reputation, clean promoters etc etc. Currently trading at 2x P/B, i think this stock would be a great buy at around 1.5x and i expect the stock to reach that level in the next 12-18 month time frame (due a combination of time decay and price decay as the bad business conditions will continue for several more quarters!)

EIL is interesting. However, one should note that the co’s business model is changing from a pure engg consultancy provider to that of an EPC contractor. the latter as we all know is highly capital intensive and will definitely bring down the RoE’s of the company going fwd. I dont understand the logic of the co’s diworsification (almost like CRISIL starting a bank!!!) except may be the management is empire building (as they know that the govt will force them to return excess cash if they continues to generate the cash flows!)

Hi Abhishek,

Can you educate more on Sintex… I agree it’s beaten down and at some point stock price should reflect all negative news but question is where’s the bottom for sintex. I know one of respected MF manager is already bullish in Sintex since long time [>150] thinking that it’s bottom and sitting on heavy loss now… Actually he was bullish on many other stocks Action construction, Pratibha and all of them are butchered like there’s no tomorrow.

What’ll be it’s profit like after considering all negative news of FCCB ? Also, can you please clarify more on FCCB part.

If we can think through FCCB and all issues through then there’s serious money to be made in Sintex.

Agree, Sanghvi Movers will need capex cycle which will take some time… This should be on watchlist to get into when all infra cycle starts turning back… [Once government gets functional and do something…] Till now it’s wait and watch for this kind of stocks…

I am sure Sugar will give very sweet return but don’t know how to identify sugar cycle and dont have stamina to get into it now.

I started accumulating EIL slowly… There may be some more pain left here but who knows bottom?

Copy-pasting from my blog post a few weeks earlier:-

_The main reason it has corrected is the currency overhang on their FCCB borrowing of $225 million. The market is assuming that since Sintex took on the loan at a rate of Rs 40.53 and the rupee has depreciated to Rs 50-51, there is a large impending forex loss.

Here is where I think the market is wrong. If you look at this year’s annual report and read through the details of the FCCB, here are some of the facts you will get.

_

_1). In respect of US$ 225 million zero coupons foreign currency convertible bonds (FCCBs) raised by the Company on March 12, 2008 during 2010-11, no FCCBs were converted into equity shares. The bondholders are entitled to apply for equity shares at a reseted price of 246.50 per share with a fixed rate of exchange on conversion of40.53 to US$ 1. On full conversion of FCCBs paid up capital of the Company will increase by 36994928 equity shares of 1 each amounting to3.70 crore.

2). Premium payable on redemption of FCCB conversion is 263.17 cr is already put in as Provisions in this years Balance Sheet._

3). Total Rs 986.11 cr Fixed Deposits. Rs. 507.11 cr are lying as unutilized amount of FCCB as part of the FD. _The 3rd point is the most critical one here. Out of $225 mn, nearly $100mn is lying unused in the bank as an FD. The company has a total of about $190 mn in Fixed Deposits on Mar 31, 2011. So, it should have no problems at all in paying back the FCCB. I am assuming they would not be converted as the price of Rs 246.50 will be tough to get to by Mar 31, 2013 when the FCCBs come up for redemption.

Sintex is also a company which has paid a dividend consistently for the last 78 years!!

Valuation
The Consolidated EPS for FY11 was 16.97. The management has guided a 20% revenue growth this year. Even if we take a conservative view and take a flat growth, at a consolidated Rs. 17 EPS, the stock is currently available at a PE of 5.1. This is less than half of the last 5 year’s average PE of 11.

If someone can hold on for 2 years from now, the expected 2014 EPS is likely to be upwards of Rs 25. At a PE of 8-10, the possible price range is Rs 200-250. That is more than a 100% appreciation in 2 years._

As to where the bottom is, I don’t know. And I don’t try to predict the top or bottom as I am not smart enough to do that. My strategy for buying any stock is to make atleast 4-5 purchases each of approx 20-25% value. Now since the stock is getting hammered everyday, I have decided that I will make the number of purchases to about 20 and each individual buy would be for 5% of my expected investment. That way I will keep buying on the way down, while it consolidates and hopefully on the way up.

Sometime, back I had asked Hitesh’s opinion on the charts of Sintex and he had mentioned that the long time support was at around 35. So, worst price-case scenario I have.

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Here is what recent Sharekhan report had to say about the debt issue.

Zero coupon FCCBs keep the consolidated debt at elevated levels: On a

consolidated basis, with Rs2,774 crore of debt on the books, the overall debt

equity ratio looks elevated at 1.15x and has been hovering in the band of 1.1-

1.35x over the last five years from the time the zero coupon convertible bonds

were issued. Adjusting for the foreign currency convertible bonds (FCCBs; which

are kept in an escrow account), the leverage position is manageable at 0.64x

And some details about working capital and free cash.

**

Working capital efficiency reflected in the free cash position: The working

capital cycle improved considerably from 155 days in FY2010 to 103 days in

FY2011, largely due to a strong execution coming from the monolithic business

and a reduction in the debtors days (from 58 days to 45 days) coupled with

reduction in loans and advances (down from 46 days to 42 days). Driven by

efficiency coming from the working capital front, the free cash for the year

came marginally positive at Rs49 crore.

What my strategy would be in sintex would be to catch it on the way up by which time things should have become more clear or else allow the stock to consolidate in a small trading range with very low volumes. I had expected the stock price to get supported at around 90 levels and around 74-75 levels but stock price seems to be in a free fall so it makes sense to see where it settles and consolidates for some time and then think about taking some position if at all.

**

Thanks Abhishek and Hitesh for detail response on FCCB and valuation!

I’ll go through their last few ARs to understand it more and will wait for stock to consolidate before purchasing! Sure, some serious and quick money can be made in this counter.

If out of 225mn FCCB,100mn are kept in FD in dollar,why do they have to provide for m to m losses on total amt ?Further isn’t it termed as bad mgt of funds,when you are not utilizing the same for so long period,why on first place you raised the same?Further what abt deal done by co at lower margin with promotors private co,without inf investors at con call ? Yes i agree,everything is ok for trading,but for serious investment candidate,do you think one should consider ?

JK Lakshmi Cement has announced its Q3 results and it has been excellent. Net sales has increased from **315 cr to 440 cr **(39.5% growth). Net profit has increased from **4.6 cr to 49.2 cr **(970.4% growth). EPS has increased from 0.4 cr to 4 cr (900% growth). Dispatches have had a healthy 12.8% yoy growth to 1.22mn tonnes and strong realization growth of 26.3% yoy to Rs. 3,359/tonne.

The management has announced an equity share buyback up to an amount of Rs 97.5cr at a maximum price of Rs 70 per share. Assuming that entire buyback happens at the price range of Rs 65-70, the paid-up equity will reduce by somewhere around 7-8%. Currently, the stock is available at a P/B of 0.7 and EV/ton of $54 both of which are at a discount to its peers.

The stock has moved up sharply in the last few weeks,from a low of 40 in the end of Dec’11 to its current price of nearly 62. The stock is still available at a reasonably cheap price and can move up significantly from here in the next 1 year. I would not be surprised if I see a triple digit price in the next 6 months.

Note: I am invested in JK Lakshmi Cement. Please take my views as biased. Consult with your financial adviser before investing.

Any views on JK Lakshmi or the cement sector in general is welcome._
_

Hi Abhishek

Excellent results(due to turnaround performance) for JK Lakshmi cements but stock has run up almost 50% in one month.

Do you know what constitutes “Purchase of traded goods” ?

Do you think this uptrend in cement cycle will continue for many quaters?

Are you tracking other cement companies like ACC or Shree cements?

Vikram,

Trying to answer your queries…

1). Company has leased small grinding facilities in NCR region. Clinker was sold to
the leased units and cement bought back from them. This constituted as ‘Purchase of traded goods’.

2). Usually cement has a 4-5 year cycle. It has been in a downturn since 2007-08 (the cement business, not just the stocks). So, it is possible that the cycle is looking at a cyclical upturn. Moreover, capacities are not getting added as before. Prices are increasing 10-20Rs per bag on a regular basis without any slowdown in demand, so may be a pointer to a turn-around in the sector.

3). I don’t track all the cement companies. But in an upmove, the north-india based companies do well to start with and then the rally moves on the other regions. The larger companies like Ambuja, ACC gain less than the smaller players like JK, India cement, shree cement etc.

Most small and mid-caps have run up in the last month. JK Lakshmi was deep value a month back, but I think it is still relatively quite cheap. The question here is IF (a big IF) the cycle is turning. If it is (and we will be sure only maybe 6-12 months down the line and by that time all cement stocks will have moved up 2-3 times!!), then it has a long long way to go. If it is not, then this is a suckers rally and I am a sucker :slight_smile:

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