Learning about investing can be a daunting task. The huge number of school of thought, the number of companies out there to learn about, you might be getting tired even before we begin. Let’s us start with some simpler concept.
What is a cyclical stock?
A cyclical stock is a company that is greatly affected by business cycles. A typical example is the commodity business. Companies such as KL Kepong (KLK: MK) or United Plantation (UPL: MK) that operates purely in the palm oil industry can be considered as cyclical companies. Their operation profit is significantly affected by the demand for palm oil which they have little or no control over.
A typical cycle for a cyclical company (COMPANY A) starts off with an increase demand for the end product. The company will then enjoy a boost in profit from the jump in demand. This leads to an accelerated expansion by the company to add capability to fulfill the demand. As competitors see the increased in business Company A is enjoying, they will also expand to catch a slice of the new business. Sooner or later, that will attract attention of speculators coming into the market due to the high profitability.
The increased competition will create an enlarged supply base which will push down the price of the product. With a drop in price, many companies will start facing losses as they might not be able to produce above the selling price of the product. As the downturn continues, this will bring many companies who are noncompetitive or with huge debt to face bankruptcy. Consolidation will occur within the industry, pushing out the noncompetitive players in the market. Slowly, the industry will stabilized and reach a more balanced supply and demand. And the cycle will restart again.
The bulk shipping industry has recently gone through the consolidation stage. We can also see that the property business in Singapore and China are both going through the same stage currently. The rubber gloves industry has seen a massive expansion over the past few years in nitrile gloves lead by Hartalega Holdings (HART: MK). The industry is starting to see some oversupply issue currently.
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It is important to know the business cycle of the companies we are interested to invest in. The first step is to look at the industry history and understand how an over-expansion can start. Once we realize that, we might even be able to spot at which stage we are currently at, giving us a better control over our investments.
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All views and opinions articulated in the article were expressed in Stanley Lim’s personal capacity and do not in any way represent those of his employer and other related entities. Stanley Lim do not own any shares from the above article.