Valuing cyclical stocks is a very different discipline from valuing non-cyclical ones. We have read recently in the financial media that Potash stock ( POT – TSX) was clearly too expensive. This Canadian company is the largest potash producer in the world (potash is a basic component of fertilizer). The stock of Potash is said to be too expensive because of its price / earnings ratio of 20, a ratio supposedly too high for a cyclical stock. I am not an expert in the field, but I doubt that the “high PE ratio = expensive stock” equation is really the right way to evaluate a producer of raw materials such as Potash.
Let’s go back in time. At the end of 2004, Potash stock is trading at 30 times profit, the stock was indeed very expensive according to the theory cited above. However, the share was then worth $ 27 and was at the dawn of a surge that was going to lead to a high of $ 230 in June 2008. At that time, the PE ratio of the stock had fallen to 20. On this basis, the stock was therefore less expensive than in 2004, and despite the multiplication by 9 of its market cap! Most people will find completely illogical that a stock can be considered “less expensive” after a ninefold increase and they are right! In fact, the PE ratio is a poor tool to evaluate a cyclical stock like Potash.
Producers of commodities are cyclical stocks because their profits follow the cycle of commodity prices. Generally, the PE ratios will tend to be high at the bottom of the cycle, because the market is anticipating a price hike of raw material and an increase of the producer’s profit. Conversely, the ratios are low at the top of the cycle, because investors do not pay a high multiple for profits that may decline in coming years. To make money, you have to buy at the botton of the cycle (regardless of PE ratios) and sell at the top (at a generally low PE).
The challenge posed by this type of investment is obviously to determine the point in the cycle we find ourselves now. For this, we must understand the mechanisms governing the supply (easiness to increase production, add new mines, etc..) and demand (who are the consumers?, what is their financial situation?, etc.. ) for a specific resource. We must also gain some knowledge of the resource historic prices. In the case of potash, the price was long depressed by the collapse of consumption in the former Soviet Union (following the breakup of the country). This created an excess supply which took more than a decade before being absorbed by the market.
In short, it is futile to attempt to evaluate a cyclical stock if we have no idea where the current price of the resource fit in the cycle. Understanding this famous cycle requires specialized expertise that is beyond the reach of a lot of people. In the case of Potash, the stock is not that expensive if potash price is at the bottom of the cycle, but that’s another story if it is in the middle … There is also a theory that fashion that we are currently in a bullish ”supercycle” for everything related to agriculture. This may be true as this may be the ag version of the “Peak Oil“ theory ! Time will tell …
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