Sun-Herald: How to pick cyclical stocks

AFR Investor section, Sun-Herald newspaper, October 2009

Cyclical stocks are those that tend to move in predictable, sweeping ways: very good in some circumstances, very bad in others, and they come and go out of favour with the behaviour of the economy. So, with Australia and the world emerging from crisis, is it time to benefit from the expected upswing in these shares?

The answer is yes, but with a caveat – to a large extent, it’s already happened. While last week’s interest rate rise gave the clearest confirmation yet that Australia is out of the woods and primed for recovery, the stock markets have been shouting this message since March. The S&P/ASX200 was up over 50% from its March lows as of October 7, and cyclical stocks have in many cases outstripped even that performance.

What are cyclical stocks? An example is a mining or resources company. Commodity prices, like oil or copper, move in clear and reasonably smooth cycles over the long term, so these shares are considered cyclical. Another is building materials. Home building tends to be much more active in good economic times than bad, so the fortunes of these shares tend to move in line with the economy.

The same is true with what are known as consumer discretionary stocks – that is, things you might like to buy but can live without if you don’t (as opposed to consumer staples, which are essential things like food). Classic consumer discretionary stocks are those like high-end retailers, stereo or gadget manufacturers, and (though this is less of an issue for the Australian stock market) luxury car producers. Many people think of media stocks as cyclical – not so much in terms of people purchasing newspapers, but certainly advertising revenues.

In all of these areas, the trend has been firmly upwards. “From the investment community’s point of view, it was important to see a recovery, and once that was obvious to the market these cyclical stocks got bought up in anticipation of a recovery in earnings,” says Simon Bonouvrie, a senior analyst at Platypus Asset Management.

Scott Bennett, associate portfolio manager at Russell Investments, adds: “We have seen positive signs coming out in terms of economic data and the resilience of the Australian consumer. That has made Australian fund managers favour domestic cyclical exposure.”

The merits of getting invested, and the strength of the run so far, depends on the area. Resources tends to be the first area that is mentioned when one talks of cyclical stocks but views vary on how the sector has performed. “Commodity related stocks have recovered pretty strongly on the back of sharp improvements in commodity prices,” says Hugh MacNally, director and founding shareholder of Private Portfolio Managers. “Copper prices have bounced back, oil prices have bounced back, and all the major resource stocks have gone up pretty sharply.” PPM holds both BHP Billiton and Origin; at the time of writing BHP was up 78% from its lows, and Origin a more restrained 28%. “The easy gains have gone but we’re still pretty comfortable with the major resource stocks: BHP, Rio, Woodside, Origin,” says MacNally. “There’s a long term growth story.”

Bonouvrie thinks that in some cases resource stocks have actually not been the star performers. “Resource share prices are interesting because over the last couple of months they have lagged recovering with the market,” he says. “You’ve had commodity prices continuing to increase and yet the share price has tracked sideways.” He notes that resource stocks tend to have strong performance into the Christmas period, reflecting the seasonality of these stocks’ performance, so there may be a good few months ahead.

If they have been weaker, this may be to do with the relative performance of Australia’s economy and currency relative to elsewhere in the world. Bonouvrie points to the strength of the Australian dollar as a dampener on rising commodity prices when viewed from Australia – because if, for example, copper increases its price in US dollars, that get cancelled out if the US dollar then falls in value against the Aussie dollar, which is what has been happening in recent months. “Commodity stocks in general need the global growth story to improve and remain on track,” he adds. “The big commodity stocks like Rio Tinto and BHP are predicated on that whole global growth scenario improving, and while that is occurring, it is happening at a slower rate than the domestic Australian economy. It could be a reason resources have lagged a bit because the market is concerned about global growth relative to Australia – by contrast you’ve seen stocks solely focused on Australia, such as banks and retailers, do particularly well.” Platypus holds both BHP and Rio.

Another interesting sector is building materials – and here the rises really have been exceptional. Boral has more than doubled since March; CSR is just a few cents short of doing so too. Following such gains, are these stocks still strongly positioned? “On a relatively short term basis, definitely,” says MacNally. “But the longer term tends to be a little less encouraging. In the 1990s and early 200s, a lot of the materials stocks were bouncing backwards and forwards and you didn’t have a long term gain for many years.” But perhaps by virtue of the scale of the reversal up to March, this could be a better experience. “We take a view that this time’s different. Perhaps the [climb in prices] is going to be much longer than what we’ve had before.”

MacNally argues that the Australian residential building cycle has been “10 years of underbuild: reasonably low levels of housing construction and quite strong population growth. So we think there’s a long-term story there.” But how to get it? He says he has been “really scratching around for something that’s suitable in residential construction”; he likes James Hardie as a business, but has problems with its structure as a company.

Bonouvrie says building stocks are on “pretty high PEs at the moment” [a PE is a price/earnings ratio, and gives you a sense of how expensive a stock is relative to what it’s earning], and does not hold Boral, although he does own Adelaide Brighton, a supplier of cement and lime to the Australian construction industry. “You need to see an increase in earnings come through over the next 12 to 18 months to justify where the share prices are today.” He notes that some building materials stocks, like James Hardie, are not just domestic plays but have a major exposure to the US economy as well. “Each of these building material companies is slightly different. A stock like James Hardie obviously needs a recovery both in the Australian and the US economies.”

Bonouvrie admires the performance of major retail companies, and holds David Jones and JB Hi-Fi. “Their share prices got hit pretty hard during the downturn but their earnings for that period actually grew, even in such a challenging economy.” And there should be more to come. “We expect these consumer discretionary stocks to accelerate through the recovery phase even further. The best gains are obviously the early ones from the lows, in percentage terms, but we think they are very good companies.” The David Jones share price is another that has doubled since its March lows, while JB Hi-Fi has done more than 150%.

Bennett also points to media stocks like Fairfax, News Corp, and smaller names such as APN News and Media. Additionally, he says some managers are trying to get hold of what he calls “cheap beta” – that is, a way of getting exposure to the broader market rally, rather than any particular stock within it. Examples of this include ASX, which operates the stock exchange, and Macquarie Group.

There’s no question that the low hanging fruit is already gone, but that doesn’t mean there’s no point in gaining exposure to cyclical stocks now – although it would be good to see some positive earnings results coming through to justify the rally. “It depends what sector it is, and how hard they’ve run relative to central earnings potential,” says Bonouvrie. “But I think as long as we continue to see a recovery in the economy these cyclical stocks will remain well sought after.”

BOX

Every quarter, Russell Investments conducts a survey of Australian fund managers to assess the mood towards the markets. The verdict: it’s positive – very positive.

In fact, sentiment towards Australian equities is at its highest level since the survey began in 2005. Russell is a multimanager, which means it allocates funds to a roster of other fund managers and is therefore very clued up on what those managers are doing and seeing; its surveys typically cover about 40 different fund managers. This time, 65 per cent of managers had a bullish attitude to Australian shares, in particular industrials and consumer discretionary stocks – cylicals.

Scott Bennett, associate portfolio manager at Russell Investments, says the rebound in stocks like building materials (see main story) was the first leg of the rally, “and now managers seem to be becoming more bullish for corporate-type plays.” By this, he means things like the media sector, which should benefit from increased corporate spending on advertising; and commercial service sectors, such as Seek, the online job recruiter. “A lot of the bullishness for these sectors has come about because of improvements in the general sentiment for the overall economy. Managers are now focusing attention on where earnings surprises are going to come from, and we are seeing that in a lot of these commercially cyclical areas.”

Another area where sentiment has clearly turned is in consumer discretionary, and this was clearly illustrated in the survey. In the fourth quarter of 2008 and the first quarter of 2009, this was considered the most unloved sector in the market. Now, it’s more favoured, with retail names like Harvey Norman and JB Hi-Fi and media plays leading the charge. “What we’re seeing is managers have gone from being overly pessimistic on consumer discretionary to their most bullish at any point in the last four years.” Russell considers this a reflection of the resilience of the Australian consumer, as well as the outlook for the economy. “While we are seeing mixed messages in the US and Europe, within Asia and Australia the health of the domestic economy has seen good support for consumer discretionary parts of that market.” He suggests Qantas is another stock that could benefit from this trend.

Colonial First State’s head of investment markets research Stephen Halmarick highlights media companies – also considered consumer discretionary – in his latest review of Australia’s markets, for September. In that month alone, he reports, Ten Network went up 16.5%, Austar United 18.7% and Macquarie Media Group 36.4%.

This week, though, the performance of the Australian economy was deemed so promising that the Reserve Bank of Australia put up interest rates. Does this change the picture for cyclical stocks?

“Obviously it’s one leg of stimulus removed from the economy,” says Bennett. “Where we’re likely to see the largest impact of that is in terms of the housing market – building materials stocks like Boral or Brickworks. A lot of the growth in the housing market in the last 12 months has been through low interest rates and the increase of the first home ownership grant. With that starting to be withdrawn, you may see a step away from those stocks.” That said, there’s a long way to go before interest rate hikes make a meaningful dent in the positive sentiment in the market.

One area where Bennett stands out from his peers is in seeing opportunity in defensive stocks. These are the ones you normally flock to in a recession: consumer staples, things you absolutely can’t do without, like basic food and beverages; power and, to an extent, infrastructure stocks (such as toll roads) fit into this camp too. One would expect these to be ignored in a rally, but Bennett argues that’s actually created an opportunity. “In the second quarter of 2009 a lot of managers were moving their portfolio towards cyclical exposures and away from defensives,” he says. “Two names that were left behind were Woolworth’s and Foster’s Group. Now, we see a lot of managers focusing on those defensive names that got left behind, because they offer more value.”