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Cyclicals:

enjoy the party, but dance near the door

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David Lerche

Senior Investment Analyst

Cyclical stocks – whose fortunes often swing more dramatically than the ups and downs of the economy – have been the primary outperformers on the JSE so far this year, following attractive returns in 2017. Whereas such stocks are often a good source of potential profits for value investors, it’s crucial to know when to exit – the trick is to both identify opportunities to buy low and to sell high, and have the conviction to take advantage of them.

Anglo American, BHP Billiton, Sasol and Mondi are the top-performing stocks in the JSE’s Top 40 Index year to date. In fact, since the beginning of 2016, Anglo American and BHP Billiton have been the best and third best performers in the index, respectively.

The high returns over the past few years serve not only as a reminder of the lows from which these companies came, but also of the cyclical nature of these businesses.

Whereas one can hold some companies forever, others one should always be ready to sell for value. Given the cyclical nature of certain industries, particularly mining, there tend to be opportunities to buy low and sell high. The challenge is to spot these opportunities and then to take appropriate action, generally against popular opinion.

The cyclical nature of the broader resources sector is driven by both the long lead times to bring new production online – for example, a new copper mine takes around nine years to start production – and the relatively low cash operating costs once a mine or factory is running. Accordingly, production volume is sticky and small changes in demand can have outsized impacts on prices for sustained periods.

HIGHER QUALITY COMPANIES

For cyclical companies, we view the industry call as more important than the company-specific call. The strength to survive through down cycles is vital, and we therefore prefer to own the higher quality names, such as BHP Billiton and Mondi, within the various cyclical sectors. These names also tend to be the lowest-cost producers.

Companies whose revenues depend on changes in commodity prices, which are largely outside their own control, naturally have lower earnings predictability, particularly in the short term.

Our rigorous investment process looks through the cycle, which is particularly relevant in the mining and commodity space. In so doing, we attempt to remove ourselves from the short-term noise in markets to find each company’s intrinsic value.

While timing prices and cycles perfectly is impossible to achieve consistently, we aim to identify where we are in the commodity cycle at any given point, and use this as a guide.

Among other factors, we compare current pricing to long-term real averages, and assess the overall profitability of the industry. Whenever margins and returns on capital reach particularly high levels, this attracts investment and tends to set the industry up for a future supply glut.

Despite attractive current returns on capital in the mining space, few major capital projects are being started, which suggests that increased supply won’t be a problem for a while yet. The difficulties of late 2015 are evidently front of mind for mining executives.

MARKET REMARKABLY RATIONAL

In general, commodity prices are currently above our estimates of their long-term real prices, which would normally point to a negative bias towards commodity stocks. Accordingly, we’ve taken some profits and incrementally reduced our mining exposure over the past 12 months.

However, the market is behaving remarkably rationally. The share prices of most mining and commodity companies don’t reflect exuberance around current spot pricing and instead factor in material future commodity price declines. The longer current high prices persist, the more likely the market is to believe they’re sustainable, thus lifting share prices further and providing the opportunity to take further profits.

Across most cyclical sectors, particularly those with global exposure, the party is still going and we’re enjoying it. We are, however, dancing near the door.

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