2020 has shown the peril, and promise, of cyclical stocks.
Coming into the year, many cyclical stocks looked cheap. But they probably should have looked cheap. Cyclical businesses are those that benefit most from the macroeconomic environment. The closer the economy is to a peak, the less sustainable a cyclical company’s earnings are. Investors should in theory pay less for those earnings, even if they don’t always do so in practice.
2020 began amid the longest macroeconomic expansion in U.S. history. And so in sectors like residential construction, auto manufacturing and boating, to name just a few, cyclical stocks traded at low multiples at the start of the year. In many cases, investors could acquire those businesses for less than 10x earnings.
Those who did learned the risks in a hurry. The novel coronavirus pandemic sent the market plunging in mid-February. Cyclical stocks were among the hardest-hit in the sell-off.
Those who timed the bottom, however, reaped often-substantial rewards. Many cyclicals have tripled or better, with casino stocks in particular seeing massive gains.
All told, an investor need only look at the last nine-plus months to understand that cyclical stocks can be volatile – and tricky. Risks are high. Valuation isn’t easy. But the rewards can be huge if the external environment cooperates.
After the recovery from March lows, the upside for most cyclical stocks isn’t quite what it was. The risks, meanwhile, persist. But there are a few attractive names in the group. These four cyclical stocks look particularly attractive – and have near-term catalysts to boot:
Cyclical Stocks to Buy: General Motors
It’s worth emphasizing the risks in GM stock up front. Yes, the stock is cheap. But GM has been cheap pretty much since it returned to the public markets in 2010 after exiting bankruptcy. Over that nearly 10-year stretch, the stock has posted a return of -9.5% (though with dividends returns at least are positive).
Meanwhile, auto manufacturing is as cyclical a business as there is. And with the likes of Tesla (NASDAQ:TSLA) promising a revolutionary shift toward electric vehicles, it’s possible that GM’s revenue and earnings have hit a peak.
That said, there’s an interesting play here at this point. It’s true that Tesla is a relatively new and significant competitor. We’ve seen several SPACs (special purpose acquisition companies) targeting the electric vehicle industry as well. Most have rallied nicely, though none have seen the massive rally in TSLA.
GM, though, is working hard on EVs itself. It’s just not getting any credit for the efforts. Tesla’s Battery Day last month received significant attention. GM released its own batteries in March, which have twice the capacity of Tesla’s, but the news was drowned out by the pandemic.
That may change at some point. And there’s a near-term catalyst as well. GM stock appears to have been pulled down of late by its association with Nikola (NASDAQ:NKLA). GM announced a partnership with Nikola just days before a short-seller released a damning report on the electric truck startup.
But as Wayne Duggan correctly pointed out on this site, GM’s deal with Nikola has basically zero risk. Investors seem to be figuring that out, as GM stock has rallied in recent days. If EV optimism adds to that recovery, the rally could and should continue.
I recommended building products distributor GMS a couple of times before the pandemic. In the “new normal,” the case still holds with GMS back at a similar price.
Residential homebuilders and construction suppliers generally have rallied in 2020. Investors are pricing in a pandemic-driven exodus from major cities back to the suburbs, which will drive years of demand. Yet GMS hasn’t quite benefited the way that rivals have.
GMS has declined 6% so far this year. The iShares U.S. Home Construction ETF (BATS:ITB) has gained 30%. GMS should have some catching up to do. And with the stock still trading at a single-digit multiple to earnings per share, valuation is far from an issue.
As always, there are risks. GMS has exposure to both Canada and commercial construction, where the outlook isn’t as bullish. As with GM, GMS stock has been cheap for some time. It’s not likely to receive even a 15x earnings multiple unless those earnings fall dramatically.
Still, there’s a path to upside. This is a well-run company with solid market share and tailwinds behind the U.S. residential business. At this valuation, that should be enough.
Recreation stocks were among the cyclical stocks hit hardest in March. They’ve been among the biggest gainers since. Manufacturers of recreational vehicles and boats historically see sales plunge when the economy turns. But stuck-at-home consumers have turned to precisely those industries to find outlets with traditional modes of travel still a concern.
Those tailwinds have benefited BRP, the maker of Sea-Doo, Ski-Doo, Can-Am, and other brands. As a result, DOOO stock has soared off its lows, gaining some 330%.
But there seems room for another breakout. DOOO still trades below peaks reached in both February and early September. Based on guidance for this fiscal year, the stock trades at about 15x earnings. That’s hardly onerous, particularly with demand likely to stay elevated through at least 2021. It doesn’t seem too late to hop aboard DOOO stock.
The epic financial engineering experiment that was DowDuPont hasn’t worked out. What were then Dow and DuPont merged in 2017 with the goal of then breaking up into three companies. Hedge fund managers loved the deal, which was supposed to both drive growth and reduce costs.
But since the split happened last year, all three stocks have struggled. Corteva (NYSE:CTVA) has traded mostly flat, while both Dupont (NYSE:DD) and DOW stock have faded. (As an aside, it’s purely coincidence that this list includes GM and GMS plus DOOO and DOW.)
The pandemic isn’t the sole cause, either. Energy industry weakness and other factors kept a lid on the stocks even before the February sell-off began.
There’s a reasonable contrarian case at the lows, however. Dow still is one of the world’s leaders in chemical production. The stock looks expensive, at about 20x forward earnings. But, again, that’s how cyclical stocks should trade when end markets are depressed.
That’s definitely the case at the moment. History suggests it will reverse. When it does, DOW might fulfill at least some of the hopes that greeted one of the largest mergers, and largest break-ups, of all time.
On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article.