What it means
Demand for some goods and services is discretionary and deferrable. A household that is worried about jobs postpones the new car, the kitchen extension and the holiday; a company that is worried about orders postpones the new machine, the new warehouse and the recruitment drive.
When confidence returns, the deferred purchases are made all at once. Companies that sell these things therefore experience swings in revenue far larger than the swings in the economy as a whole, and because many of them have high fixed costs, the swings in profit are larger still.
A 30% fall in a steel producer's revenue can eliminate its profit entirely; a 30% rise can double it. This operating leverage is the defining characteristic.
A company with high fixed costs (plants, fleets, workforces that cannot be scaled quickly) converts each dollar of additional revenue into profit at the contribution margin, which is far above the average margin, on the way up, and loses profit at the same rate on the way down. Financial leverage compounds the effect: cyclical companies that carry debt find that interest is a fixed cost too, and that lenders become nervous exactly when the business is weakest.
The combination explains why cyclical shares are more volatile than the market, with betas above one, and why they lead the market into and out of recessions. Valuing a cyclical stock with the tools used for stable businesses produces systematic errors.
The price-to-earnings ratio is the classic trap. At the peak of a cycle, earnings are at their highest and the share price, which anticipates the downturn, has stopped rising, so the ratio looks low and the share looks cheap; this is precisely the wrong moment to buy.
At the trough, earnings have collapsed, the price has already fallen and is anticipating recovery, so the ratio looks very high and the share looks expensive; this is often the best moment to buy. Experienced investors describe cyclicals as looking cheapest at the top and dearest at the bottom, and they avoid the ratio in its naive form.
The alternatives are to normalise earnings, to use measures that do not depend on current earnings, or both. Normalised or mid-cycle earnings apply the company's average margin over a full cycle to its current revenue, or its average return on capital to its current capital base, to estimate what it would earn in an ordinary year; the share price divided by that figure gives a normalised price-to-earnings ratio that is comparable across the cycle.
Price-to-book, price-to-sales and enterprise value to sales are less distorted by the earnings cycle, though they must be read alongside the company's normal margins. Balance sheet strength matters more than for a defensive company, because the question with a cyclical is not only what it earns but whether it survives the trough to earn it.
Investors use cyclicals in two ways. Sector rotation moves money into cyclicals when a recovery is expected and out of them into defensives when a slowdown approaches, which requires the difficult skill of timing the cycle.
A longer-term approach buys good cyclical businesses when they are unloved, at trough valuations, and holds them through the recovery, accepting that the timing of the recovery is unknown and relying on the balance sheet to carry the company through. Both approaches depend on recognising that the reported earnings are a snapshot of a moving picture.
In practice
Real-world examples.
Example
A housebuilder reports record profits and a price-to-earnings ratio of 7 at the top of a housing boom; two years later its profit has fallen 85% and its share price by 60%, and the ratio was a warning rather than a bargain.
Example
An airline trades at 40 times depressed earnings after a downturn; an investor who models mid-cycle margins buys it, and as traffic recovers the shares double while the ratio falls to 9.
Example
A fund manager reduces holdings in capital goods manufacturers when leading indicators turn down and increases holdings in food producers and utilities, then reverses the trade eighteen months later.
Think of it
“Cyclical stocks rise and fall with the economy-they boom in good times and bust in bad.
Formula
Calculation
Mid-cycle operating profit = Current revenue x Average operating margin over the cycle
Normalised earnings per share = (Mid-cycle operating profit minus Interest) x (1 minus Tax rate) / Shares in issue
Normalised price-to-earnings ratio = Share price / Normalised earnings per share
Operating leverage = Percentage change in operating profit / Percentage change in revenue
Beta = Covariance of the share's returns with the market / Variance of market returns
Worked example. A steel producer has 200,000,000 shares, interest of $50,000,000 a year and a tax rate of 25%. Over the last ten years its operating margin has averaged 7%.
- At the cycle peak: revenue $5,000,000,000; margin 14%; operating profit $700,000,000; net income ($700,000,000 minus $50,000,000) x 0.75 = $487,500,000; earnings per share $2.44; share price $30; price-to-earnings ratio 12.3
- At the trough: revenue $3,500,000,000; margin 2%; operating profit $70,000,000; net income ($70,000,000 minus $50,000,000) x 0.75 = $15,000,000; earnings per share $0.075; share price $12; price-to-earnings ratio 160
- Operating leverage: revenue fell 30% (from $5,000,000,000 to $3,500,000,000); operating profit fell 90% (from $700,000,000 to $70,000,000); operating leverage = 90% / 30% = 3.0
Normalised view. Mid-cycle revenue of about $4,200,000,000 at the 7% average margin gives operating profit of $294,000,000; net income ($294,000,000 minus $50,000,000) x 0.75 = $183,000,000; normalised earnings per share $0.915.
- At the peak price of $30, the normalised price-to-earnings ratio is $30 / $0.915 = 32.8, not 12.3: the share is expensive
- At the trough price of $12, the normalised ratio is $12 / $0.915 = 13.1, not 160: the share is reasonably priced
The naive ratio pointed in exactly the wrong direction at both ends of the cycle. The normalised ratio, combined with a check that the company's debt and liquidity can carry it through the trough, gives a usable basis for a decision.Case study
Seen in the real world.
Two private investors bought shares in the same housebuilder at different points in the cycle, and their experience illustrates the trap and its avoidance. The first bought at $40 near the peak, when earnings per share were $5.00 and the price-to-earnings ratio was 8, well below the market's 16; the shares looked cheap on the only measure he used.
Within two years the housing market had turned, earnings per share had fallen to $0.50, and the shares were at $16, a loss of 60%. He sold, concluding that housebuilders were uninvestable.
The second investor was interested at that point. She ignored the price-to-earnings ratio, which was now 32 and looked expensive, and looked instead at the balance sheet and at normalised earnings. Book value per share was $22, so the shares at $16 traded at 0.7 times book, and most of that book value was land bought at prices below current values.
Net debt was low, the company had cut its dividend and its land buying, and it had enough cash to trade through two more weak years. Over the previous full cycle, earnings per share had averaged $2.80, so the shares stood at under 6 times mid-cycle earnings. She bought at $16.
Three years later, with the market recovered, earnings per share were back at $3.50, the shares were at $34, and she had made 112% plus dividends. Her price-to-earnings ratio at purchase had been 32 and at sale was under 10; on the naive measure she had bought expensive and sold cheap. On the normalised measure she had done the opposite, which is the only measure that works for a cyclical.
Watch out
Common mistakes.
- Buying a cyclical because its price-to-earnings ratio is low at the peak of the cycle, when peak earnings are about to fall, and avoiding it because the ratio is high at the trough, when depressed earnings are about to recover.
- Ignoring the balance sheet, when the essential question for a cyclical is whether it can survive the downturn; a company with high operating and financial leverage may not reach the recovery.
- Treating all companies in a cyclical sector alike, when the strongest operators gain share in downturns and the weakest fail, so the sector's recovery is not evenly distributed.
Questions
People also ask.
What makes a stock cyclical rather than defensive?
The nature of demand for its products. Purchases that can be postponed (cars, houses, machinery, travel, luxury goods) are cyclical; purchases that cannot (food, utilities, medicines, basic services) are defensive. High fixed costs amplify the effect.
How should a cyclical stock be valued?
On normalised or mid-cycle earnings rather than current earnings, supported by measures such as price-to-book and enterprise value to sales, and with explicit attention to debt and liquidity through the trough.
Are cyclical stocks bad investments?
No. They are volatile, and they punish investors who buy at the wrong point using the wrong measures. Bought at trough valuations with a sound balance sheet, they have produced some of the largest returns available in equity markets.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%