Misunderstood Cyclicals What Buffett And Lynch Say Will Make You A Better Investor

TITLE: Misunderstood Cyclicals - What Buffett and Lynch Say Will Make You a Better Investor CHANNEL: Curreen Capital DATE: 2017-07-07 ---TRANSCRIPT---

• Hey there! I am Christian Ryther of Curreen Capital and today I want to talk about cyclical stocks. Peter Lynch called these the most misunderstood of all the types of stocks and I own a few of them so I’ve been thinking about it a lot lately. And so what I’ve been doing is looking at what Peter Lynch has said, what Warren Buffett has said, trying to put that together in my mind and maybe come to some conclusions or at least gain some insights about how to invest in cyclicals without totally losing your shirt. Because another thing that Peter Lynch said is that if you’re good at cyclicals, you can make your ten baggers here. If you’re not good at cyclicals, you can lose 80% to 90% of your money, and they are, again, misunderstood stocks. So what am I talking about with cyclicals? What do I actually mean by that ‘cause different words mean different things to different people. For me, a cyclical is a business or a security that depends on some underlying factor or force which lasts longer than one year. So these are multi-year things. We’re not talking about the difference in turkey sales between Thanksgiving and, you know, every other period of every other week of the year, or Christmas tree sales, or flower sales on Valentine’s Day versus, you know, March 14th, stuff like that. That’ll be sort of addressed by our calender year accounting statements. But cyclicals are driven by forces that last longer than the calendar year. So when you look at them based on their one year financials you might not be getting the full picture, you’re probably not getting the full picture. And so we have at these things in a different way and I don’t think that we as humans understand this stuff intuitively. Like, there are some things that we can’t see. Not because they happen too quickly but because they happen too slowly. Like, watching grass grow is really boring because you don’t see anything happening, but at the end of the year, if you don’t mow the lawn, there’s gonna be a lot more grass there, right? So we know that there are things that operate on these longer cycles than one year, but we aren’t necessarily going to understand them intuitively. So, that said, what has Peter Lynch said about cyclicals? So Peter Lynch, in my understanding, is always, always wants to be on the side of growing earnings. He wants to have business momentum operating in his favor. So when it comes to a cyclical, the Peter Lynch dream play is to come in and buy the stock when it’s really low. So the cycle maybe hasn’t even turned yet or it’s in the very early stages of turning. You want to see a business that can handle adversities so it doesn’t have a debt burden, it’s gonna, like, crush it if things, you know, if there are hiccups along the way to this multi-year boom that you’re gonna get. You want to see shrinking inventories. You want to see rising prices, rising used car prices or rising commodity prices, like something demonstrating that pent up demand is finally starting to be addressed. So you’re gonna have that pent up demand plus that sort of normal steady state demand. There will never be a steady state but you’re going to have those tailwinds helping you. So he wants to get in at that time at those prices when P/Es are super high because earnings are super low. So again, you’re coming in at high P/E when things look bad and have looked bad for years. He then wants to hold on, he does not want to be shaken out by a 50% gain, by a double or even a triple. He wants to hold on for the years that it’s going to take for that pent up demand to be absorbed. So he’s riding it, he doesn’t want to get shaken out, he wants to make a ton of money on this long pull. And then he’s going to sell it when things look great, you’ve had years of record earnings. the P/E has shrunk, maybe even single digits. He’s got this great quote where he says buying a cyclical at a single digit P/E after a period, on record earnings is a proven way of losing half your money in a very short period of time. And I love that quote. That’s the Peter Lynch dream play and I think there are a few things that we can get out of that. You don’t want to be doing it differently than Peter Lynch did, as Peter Lynch would love to do. So you don’t want to be buying a cyclical business after a period of record earnings when the P/E has shrunk. That is a value trap. That is a danger sign with that low P/E. But very high P/E, weak miserable past results, you know, terrible losses or low returns on capital, that might actually be a great sign with a cyclical, because again, these are the most misunderstood of the types of stocks. So those are some things that we can get out of Peter Lynch. You want to ride that earnings trend and it’s gonna be multi-year, don’t get shaken out. So what does Buffett add to this? You know, obviously a lot because Buffett is a genius and what’s useful is that he has been writing chairman’s letters that are on the website for decades now. There are 39 years, going back to 1977’s chairman’s letter on the Berkshire Hathaway website. So there are a lot of things that he’s talked about. He talks about tailwinds and headwinds, he talks about the tides going in and out, he even talks about the sun setting and rising. Like, he’s got a lot of metaphors for us to think about how businesses rise and fall with some sort of semi-regular pattern. What he adds to what Peter Lynch has said is first Buffett buys whole companies, so it’s not the securities of things. And when he buys whole companies, he seems to be happy to buy them as the sun is setting, as the cycle is peaking and the P/E has shrunk dramatically. He says that the intrinsic value is unaffected by the cyclical nature of the earnings Because a dollar is a dollar however much it fluctuates in-between, like you add them all together, you discount and you get the value. That’s what he does. So the intrinsic value is unaffected by the cyclicality, according to Buffett. He’s happy to buy whole businesses at the peak of a cycle or as it’s coming down. And he’s evaluating the business over that entire cycle. So he’s not evaluating it on any shorter period of time, he’s looking at the entire cycle and evaluating the businesses there. He also, because he’s Buffet and when he wants to own something for many years, he wants to have a good business. So he’s evaluating these cyclical companies over the full rise and fall and then rise again and fall again of the cycle, and saying is this a good business over that full timeframe. And that’s useful because we want to be looking at this not over the past five years, which might be terrible or might be good, in either case it’s probably misleading. We want to be able to look at it over a very long period of time with some up and down cycle, to get a sense for: is this really a good business, or is it just that we’ve been in a boom these past few years? Or is this really a mediocre business? Or is it just that it’s been in a weak period and it’s actually an outstanding business and now is exactly when we want to be buying it despite the fact that the numbers look terrible right now? So that’s something that Buffett adds to it. Look at it over the full period of the cycle. Buy the good businesses, not just the ones that look good. And I think here he differs from Peter Lynch. I think Peter Lynch would be happy to buy a mediocre business whose earnings are about to quintuple and give him a four or five bagger in a crappy business because it’s just gonna be moving on. Buffett at least talks about wanting to own these great businesses for a longer period of time. Buffett does talk about headwinds, and in the 1979 letter talking about interest rates, he said that it was a mistake for him to own medium-term bonds, which I would call a cyclical security, because he felt that the headwinds would be so fierce. So it seems like when he’s talking about investing in securities, Buffett is in line with Peter Lynch where he does not want to face crazy headwinds for a long period time. Even if those headwinds are just cyclical. If he can own the business, maybe he feels better about it, but he doesn’t want to ride those things down. So how do we put these things together? So we’ve got what Buffett has said, we’ve got what Peter Lynch has said. They don’t quite line up but there are some useful things here. I think for me, I want to be like Buffett in that I want to evaluate these businesses over the full span of the cycle. I want to make sure that they’re truly good businesses and they don’t just look like good businesses because the past seven years have been great, or don’t just look like bad businesses because the past seven years have been bad. I need to look at the full history. If I can. You can’t always get that data but that should be something that you’re thinking about in the back of your head. Like am I being fooled by the timeframe that I’m looking at because again, maybe the accounting should be over, like, a 10-year period. The second thing is that the intrinsic value is unchanged depending how cyclical it is, but the market might not agree with you. So again, there might be opportunities there. But they’re going to be in those Peter Lynch style buys where things have looked crappy for a long time but you have evidence or a strong reason to believe that that is turning and you’re in something that will last for years. So I want the good businesses from Buffett. I want to evaluate them over the right time period. But then, I want to be buying and holding and selling the way Peter Lynch would. So with autos right now I want to be selling. (laughs) With oil right now I probably shouldn’t be in it at all, if I’m a Peter Lynch guy. And with housing, I’ve got to hold on, hold on through any hiccups and dips and, you know, why are housing starts so weak right now. They should be growing much faster but I need to hold on anyway. So that’s what I’ve taken from my look into what other smart people, you know, smarter than me people have done with cyclicals. And I hope that it’s useful for you. So if you like this video, leave a like. Subscribe and please leave a comment below. Tell me what you think about cyclicals, things that I missed, things that you benefited from this, what you’re going to do differently maybe. And I hope you have a great day. Thanks, everybody! Bye.