Screening for cyclical stocks

Cyclical stocks are those that have high correlation with economic activity and thus see a lot more volatility in revenue and earnings. Typical examples will be banking, cement, metals & mining etc. However, one needs to be very careful when categorizing companies into cyclical or non-cyclical. Not all banks need to be cyclical because sometimes lack of private sector credit growth can be offset by financing the government. Similarly companies which we would generally consider displaying secular growth characteristics might turn out to be more cyclical.

Screening for cyclical companies are a bit trickier than others. This is because simple extrapolation of the trends will often lead to over or underestimation of fair value. In addition, at the bottom of the cycle earnings might be exceedingly low (as some costs remain fixed while sales drops) resulting in an extremely high Price/Earnings ratio which may cause people to unfairly tag the company as overvalued. To deal with these issues here are some tips on the subject.

  1. Use a sales multiple for screening: Instead of the more commonly used P/E ratio it makes a lot more sense to use a Price/Sales or better yet an Enterprise Value/Sales ratio. This will help negate the impact of operation leverage that causes profit to drop sharply in an economic downturn.
  2. Watch out for replacement value:  One good strategy is to compare enterprise value of listed equities with their replacement values. When they are trading very near or below their replacement value, it makes more sense for a potential acquirer to buy out the listed company rather than make a new factory.
  3. Leverage is an useful indicator: When the entire sector becomes highly leveraged it is a good bet that capacity additions will become slower and eventually demand-supply parity will come back in the industry. Also, in a cyclical downturn, companies with strong balance sheets can become opportunistic and acquire over-leveraged competitors at rock bottom prices.
  4. Some companies can be defensive to the cycle: Integrated oil companies like Exxon Mobil might not be as hurt as those which only have Exploration & Production business. That is because, in a oil price decline while the E&P segments will perform poorly the oil refinery business can benefit from higher margins (the drop in retail oil prices has been lower than the drop in crude oil prices resulting in thicker margins for refiners).

These are few methods that can be put to use by equity analysts. Obviously screening is just the first stage of idea generation and one needs to do further analysis and due diligence before making the investing decision.

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Things stock screens miss out

One very popular method of getting investment ideas is running stock screens. For those of you not very familiar with ‘screening’ here is a basic video. The idea is to filter out companies using basic parameters like Market Capitalization, Average Daily Trading Volume, Price to Earnings ratio to cut the investable universe to a more manageable level. Then comes a closer look like checking profitability (ROE, ROIC) , growth (revenue and earnings growth) and different valuation metrics (P/E, EV/EBITDA, P/B) to narrow the list even further for closer inspection.

However, stock screen has its fair share of issues. It is useful to know these while using screens and comparable sheets. I am in no way saying that we should avoid using screens altogether but rather saying that they should be used while remaining aware of the shortcomings.


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