Sunday, April 22, 2018

The Cyclical game is not for long-term investors, but it can make you a fortune


Warren Buffett’s system to investing in stocks is in some ways simple.  He always asks what the company’s competitive advantage is. For example, Coca Cola’s brand is so strong that when they sell the stuff and no changes are required (such as product adjustments due to health concerns) it is very difficult to compete with it. In some ways, Coca Cola is not a beverage company (anyone can make a cola-like product) but it is a marketing giant. It is nearly sect-like when they have people that swear by Coke versus those that are fanatical about Pepsi.  Really? Nobody can make ketchup like Heinz?  That is what Warren calls the moat around a company. Other moat examples: Microsoft Windows, iTunes and other Apple products.
Secondly, Warren needs predictable cashflow from his investments.  No accounting chicaneries and with earnings that can be extrapolated for many years into the future along a nearly straight line. Because then it is easy to calculate the intrinsic value of a company. We have done that on this blog also in the past. In addition, Warren uses his insurance company (or better companies) to provide him with interest free money owned by other people (insurance premiums).  Thus, he uses very cheap leverage to increase his earnings even more. But financial engineering is not today’s topic.
Many companies have a much less predictable ‘future earnings stream’. Warren may want to keep his companies ‘forever’ but if you invest in companies with less earnings visibility you’d better be ready to run at the first sign of trouble.  Oil and gas companies are an example of that kind of investment, which often is referred to as cyclical investments.  Most resource companies such as mining, fertilizer, or agricultural companies are cyclical.  When dealing with a product made in mature technology industries (i.e. car manufacturing) they become cyclical as well.  Look at PC makers, they used to be leading edge technology companies; or smart phones, same thing. When these products mature they no longer can charge premium prices and the number of computer manufacturers, or today smart phone makers, go through the roof. They start to compete more and more on price instead of based on superior technology. Thus, this once high margin specialty business becomes like a commodity with no special pricing power other than supply and demand. They evolve into a cyclical industry. Companies like Apple and Samsung try to keep enticing us with ‘revolutionary technology improvements’ and thus stand out above the crowd. Yet, they are gadget makers on the cusp of losing their special appeal just like Kodak or Blackberry before them. They become ultimately cyclical.
Cyclical companies rise and fall on supply and demand.  If times are good, gold mining companies crank out as much as they can, and the production costs barely matter as everyone wants to own gold.  Then suddenly everyone (the market) realizes that we produce more gold than people want to own. Demand dries up or just slows and gold prices, like in 2011, crash. A bear market for gold has arrived. Companies have overinvested, many managements took on enormous debt (it is amazing how short-term management teams think and not just because they are dumb) and the bear market will separate the men from the boys. One after the other mismanaged gold company goes out of business and if you invested in this stuff, your share prices can easily fall 70 or 80 or 100% from their peak.  Supply of gold crashes; ‘everybody hates gold’ and nobody wants to produce it and sometimes slowly, other times quickly, a new supply shortage develops; the cycle repeats it self. We have seen this happen in gold, in uranium and of course in oil and gas. What about autos? Same thing, remember 2008 and the GM bankruptcy?
Thus, investing in cyclical companies is not for the faint of heart and it is certainly not long term.  You buy when everyone hates the industry with a vengeance such as today with Alberta oil and gas; preferably when you start to see some ‘green sprouts’ showing up along the industry’s waste land. You buy dirt cheap and you wait for demand to take off. Sometimes it can take years before it takes off and then your investment is dead money until… It is often a question of when not if. The cycle always repeats in one form or another. Multistage fracking in horizontal wells truly disrupted the previous oil and gas cycles. We went from a ‘peak oil’ model to a model of endless and cheap supply. “Oil and gas are passé”, those of limited brain power and faulty memory tell us. "We are living through a technology revolution." That is true. Because in the past, we could only produce from good quality reservoirs with high flow capacity (in the oil industry that is called 'high permeability').  Modern technology allows us to produce from nearly waterproof rock such as concrete. Today we produce from rocks that have very low flow capacity. The volume of rock that can be considered reservoir, and thus recoverable oil reserves, has increased enormously. It is more expensive to produce from those rocks but over the past decade companies have drilled massive numbers of horizontal wells that has led to oversupply.  It restored the oil and gas production capacity both in the U.S. and Canada, with the U.S. producing at all time high rates of over 10 million barrels per day! More than Russia and more than the Saudis!

The new technology also opened opportunities in other parts of the world. In Poland and recently in the Middle East. Europe would also be able to produce a lot more, but this technology with horizontal wells stretching out several kilometers and spaced just hundreds of meters apart does not go over very well in densely populated areas such as large cities.  Do you really want one or two of these horizontal wells below your city block?
But after fighting the oversupply that $100 per barrel oil combined with this new technology created for several years now, oil production and somewhat less so gas production has fallen off while demand has increased. Now we enter a period of supply shortage and… rising oil prices.  This is probably the time that the cycle turns up again and to load up on many commodity stocks. Gold is off the bottom as well and there are signs uranium and silver are turning. Coffee may become more expensive as well.  Rising commodities often translate into inflation and visa versa.  Increased government spending and debt also are inflationary and thus we are looking for a new uptrend in the ‘currency commodity’ as well, i.e. rising interest rates.
But whether you decide to invest in these, often very lucrative, cyclical industries or not, be aware that they are very volatile and risky. If you don’t like the game of musical chairs for stocks in general, then investing in cyclical industries is like an extreme sport.  Different types of industry require different types of investment styles.  One of these days, I’ll discuss here what style is required to invest in high-tech.

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