How to Analyze a Cyclical Stock?

Earlier, we discussed the concept of cyclical stocks and why to choose them? However, the question of how to analyze cyclical stocks remains unanswered. Let's get started with it in this unit.

A top-down approach will help you pick a sector ripe for an up move. Next, use a bottom approach to identify a company that ticks all boxes.  There are a lot of things to keep in mind while analyzing a potential investment in cyclicals, namely:

1) Industry dynamics- Jumping into a stock without understanding the industry dynamics is a perilous task. Know the business inside out before you put your money. For instance, I've seen many gullible retail investors buying into sugar stocks with absolutely zero knowledge about the functioning of the industry. The Indian Sugar Industry is highly regulated. It remains virtually paralyzed due to oversupply and is currently hiving off government subsidies. There is no doubt about the fact that the Ethanol policy is a game changer and its proper implementation will be keenly watched.

2) Market positioning- Let us say you have zeroed in on a particular sector. The next logical step is to pick a company that can outperform its peers in terms of returns. Every company may not be adequately positioned to take maximum advantage of the ensuing bull run. For instance, there is a very high divergence in Sales and profitability between North-based & South-based cement companies. Oversupply has long been a bane for the Southern region given the high concentration of limestone reserves (a key raw material in cement production) in the region.

3) Macro-environment- The prospect of some industries is also linked to the overall health of the global economy. Metal stocks are front-runners in market rallies when the macro environment is on a sound footing.

4) Government policies- The Government of India is the only consumer for industries engaged in the manufacturing of fighter jets, missiles, explosives, and the like. Any change in India's foreign policy can have a cascading effect on the fortunes of the defense sector. Similarly, government subsidies act as a lifeline for many industries such as Sugar and Fertilizers.

5) Raw material & finished product prices- One can track the prices of finished products as an indication of strength or weakness. It is important to check three parameters in this regard.

The first thing to check is whether the rise in prices of finished products accompanied by a rise in its cost of production. If the answer to the above question is no, then it is irrelevant. However, if there exists a positive correlation between the two, one must look for companies that are backward-integrated and self-sufficient in raw material production. An integrated player makes a better case for investment since it is protected from price fluctuations.

Secondly, one must analyze the pricing power and demand sensitivity of the company's product portfolio. Let's take up the hypothetical scenario of a Fertilizer company. There has been a significant increase in the price of urea, hiking the overall cost of production for the firm. It may happen that the firm is unable to increase the prices of its products due to cut-throat competition or nascent demand recovery. Hence it is always advisable to look for companies with strong pricing power and brand equity.

 A few other pointers to note down:

1) Keep a close watch on inventories & the supply-demand relationship. Watch for new companies entering the market, It is usually a dangerous development.

2) Stocks with a very low Trailing Price to Earnings multiple might indicate the end of the cycle as peak earnings have already been factored in

3) The lower the Price to Book Ratio, the greater is the comfort of ownership

4) Low shareholding of institutional investors is a positive sign.

5) Insider buying and Stock Buybacks are a testimony to the strength of the cycle

6) Check whether the company has a comfortable Debt-Equity ratio of not more than 1:2