Posts Tagged ‘cyclical’

Closing in for the kill in value investing

Monday, January 3rd, 2011

In our previous two articles, Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses and Choosing the businesses with strong economics- Part 2: finding durable competitive advantaged businesses, you have learnt about which businesses to avoid and which ones to look out for as your investment candidates. Once you have identified such businesses, the next question is, when do you make a move to invest in them?

First, you need to have some idea how much that business is worth. Our previous articles, Measuring the value of an investment and Effects of inflation on value of investment will give the mathematical explanations on how to value a business. But do not confuse mathematical precision with accuracy. As we said before in Confusion between precision & accuracy,

As the above-mentioned analogy shows, precisely wrong numbers are useless. If we use them, then the quality of our investing decision will degrade considerably.

For this reason, it is better to be vaguely right than to be precisely wrong.

Second, you must remember this: never ever pay for more than what the business is worth. In fact, it is advisable that the price you pay be of a certain margin (say 15%) below its worth. This is to give you a margin of safety against errors in judgement.

The next step is to wait patiently, stalking the business like a hunter. Eventually, bad news will strike the business, revealing the changes that will occur. Then the stock market will typically overreact, pulling the stock price to a level that is far below what it is worth. That will be the time to strike. The stock market overreacts because it is not rational and suffers the common mental pitfalls that ail every human. To be a successful investor, you need to be more rational than the market collectively. We recommend that you familiarise yourself with the common mental pitfalls as explained in our guide, Common mental pitfalls that leads you astray and Why are the majority so wrong at the same time and in the same ways?.

However, this step is the trickiest one and errors in judgement are most likely to be made. Bad news comes in two flavours:

  1. Changes to the business are temporary and therefore, a recovery will eventuate in due time.
  2. Changes to the business are permanent and therefore, there will be no recovery.

Thus, you have to discern the nature of the changes, understanding whether the context of the underlying trends in which the business changes occur is secular or cyclical (see Understanding secular vs cyclical). For example, as we explained before in Should value investors be ?bullish? in a bear market?,

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ?typical? bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current ?Buy? recommendation will be very wrong.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

This is where value investors are most likely to get wrong.

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Posted in Investor Education, Value Investing | No Comments »

What the commodities super-cycle is and isn’t?

Wednesday, November 12th, 2008

There are many skeptics of the commodity super-cycle. They have seen the rise of commodity prices as a bubble and consequently, see many resource stocks as being extremely over valued. The recent reports by the media of “fears of a global slowdown” and a significant slowdown of China prompted the sell-off in commodities and thus, add fuel to the belief that the commodity bull market is over.

On the other hand, there are many ardent believers of the commodity super-cycle theory. They sees that China and India are going to de-couple itself from the Western world and power the global economy regardless of what happens to the United States. Consequently, they see that commodity prices are not in a bubble and there is more to go. As a result, they start to bid up resource stocks to a sky-high level.

For us, we believe there are some truths in both camps. Yet at the same time, both camps tend to exaggerate the truths in their beliefs, resulting in bad long-term investment decisions. Both camps fail to understand the big picture and let the short-term price movement cloud their judgement. Today, we will repeat this explanation, for the sake of our newer readers.

Let’s turn to our earlier article, Understanding secular vs cyclical,

One of the most important distinctions that investors have to understand is the difference between secular and cyclical trends. Confusion between the two can result in lost profits or worse still, losses. Before we can give examples of secular and cyclical trends, let us begin with definitions from the Encarta® World English Dictionary:

Secular – occurring only once in the course of an age or century; taking place over an extremely or indefinitely long period of time

Cycle – a sequence of events that is repeated again and again, especially a causal sequence; a period of time between repetitions of an event or phenomenon that occurs regularly

Now, let’s turn to Example of a secular trend- commodities and the upcoming rise of a potential superpower,

It has been said that today?s 21st century will see the secular rise of China. During the 20th century, China endured non-stop revolutions, civil wars, invasions, social upheavals, ideological experiments (e.g. Cultural Revolution, Great Leap Forward). It was the last couple of decades of the 20th century that China began to slowly emerge from her self-imposed shackles to catch up with the West. Napoleon once said that China is a sleeping giant that will shake the world when awaken. Today, despite the breakneck growth of the Chinese economy, China still have a lot of catching up to do in order to attain the same level of affluence, standard of living as the West- there are still hundreds of millions of peasants in China that is still relatively poor by Western standards.

To be a successful long-term investor, you have to appreciate the magnitude of the length and scale of this long-term secular trend. To help you do so, consider these real-life scenarios:

  1. Sydney is considering building a desalination plant that is projected to be completed in 2009. This project began as an investigation in 2004.
  2. A proposed brand new railway line from Rouse Hill in Sydney to the city may take up to 2015-2017 to complete.

So, you can see that major large-scale capital infrastructure projects can take several years to complete. In these examples, we are citing only a desalination plant and a railway line.

Now, take a look at China. They have plans to develop their nation towards the Western standard of living. They still have hundreds of millions of poor rural Chinese living in the countryside who have yet to taste the newly-found wealth of the coastal cities. Ditto for India. Combined, both of them have around 2.5 billion people. Can you imagine the colossal magnitude of the tasks ahead? If a Sydney desalination plant and railway line requires so much time, material and financial resource to complete, imagine how much more is needed to develop two nations with gigantic populations to a level that we, who live in the West, now enjoy? Whether they eventually succeed is irrelevant. The fact is, they are going to try, with major consequences to the rest of the world.

So, you should be able to see by now, the development of this secular trend will require decades and colossal amount of resources and commodities to come into fruition. This fact is the basis for the commodity super-cycle theory.

But life is not always so straightforward. As we said before in Will the China boom go in a straight line?,

However, the market always latches on to the generalities of a story and takes a simplistic projection of the story too far into the indefinite future. What do we mean by that? Put it simply, we do not believe that the rise of China will take on the path of a straight line.

As we said before, this trend will take decades to come into fruition. Within the decades, there will be business cycles, setbacks, problems and so on. As we wrote in that article,

Any time when the path does not look like a straight line upwards and take a temporary dive, the market will flip to the other extreme of this story and project extreme pessimism into the indefinite future.

Currently, with commodity prices taking a beating over the past couple of months, there are some who believe that the commodity bull market is over. Well, isn’t this taking a too short-sighted view?

Furthermore, let’s say China falls into a major economic correction in the near-term (see Can China really ?de-couple? from a US recession?)- we believe this is a real possibility. Does this mean that’s the end of the bull market for commodities (note: we are NOT talking about stocks here)? That is, will China’s long-term needs for resources and commodities going to decline from then on, forever and ever and return to the stone-age just because of a recession? We are sure there will be many experts pronouncing the end of the China growth story when such a day comes. To use an extreme example, it looked that way too for the US during the 1930s during the Great Depression. But history proved that’s not the end. In fact, the US went on to become a superpower in the 20th century. But on the other hand, if China falls into perpetual anarchy/revolution, then all bets are off and we will have to reconsider the commodity super-cycle theory.

The point we are trying to bring across is that this secular commodity trend is a very long-term trend that will take decades to unfold. Within this secular trend, there will be cycles of bad years. But do not mistake these cycles of bad years as a permanent decline that will stretch on forever and ever.

Understanding this big picture is one thing. Translating this understanding into a successful investment strategy that is suitable for you is another. In fact, it is tricky and many pitfalls and potholes lie on the road.

Firstly, since this is a multi-decade trend, some of us may not live that long enough to see it, let alone invest in it. For young working adults who have an expected lifespan of 50 or more years to go, it may be feasible to ride on this secular trend.

Secondly, for many of us, to take advantage of the commodity trend, the only available avenue of investment is through resource stocks. As we mentioned before in What is the meaning of ?oversold?? Part 2: Value perspective,

But having said that, remember that as we said before, all mines/oil/gas fields have a finite life. In the absence of potential new production from future exploration and mining development projects, a mining business will cease after a estimated number of years. The implication is that if the downturn is severe and long enough, some mining businesses may not last long enough to be able to realise the value of the long-term inflationary trend of commodities.

Thirdly, even though this secular trend have decades to run, you still have to decide (1) when is the right time to invest in it, (2) which commodity-related investment vehicles/stocks to put your wealth in and (3) at what price to pay for it. For example, if you enter during the cycles of bad years, you may end up with major disappointments in your investment results. As such, you will have to consult other research and professionals who will take your personal situation into consideration for advice as this is beyond the scope of this article.

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Posted in Commodities, Looking Forward, Market Observations | 10 Comments »

Example of a secular trend- commodities and the upcoming rise of a potential superpower

Wednesday, March 19th, 2008

In the 19th century, Great Britain was the superpower of the day. She was an empire with colonies, commercial interests and trading posts all over the world. Her navy was unrivalled, patrolling the world’s seas. Her currency, the Pound Sterling, was much of the world’s primary reserve currency during the 18th and 19th century.

The 20th century saw the secular decline of the British Empire. Two world wars and economic weakness resulted in the Pound Sterling losing the reserve currency status. At the same time, the 20th century saw the secular rise of the United States into an arguably, empire.

It has been said that today’s 21st century will see the secular rise of China. During the 20th century, China endured non-stop revolutions, civil wars, invasions, social upheavals, ideological experiments (e.g. Cultural Revolution, Great Leap Forward). It was the last couple of decades of the 20th century that China began to slowly emerge from her self-imposed shackles to catch up with the West. Napoleon once said that China is a sleeping giant that will shake the world when awaken. Today, despite the breakneck growth of the Chinese economy, China still have a lot of catching up to do in order to attain the same level of affluence, standard of living as the West- there are still hundreds of millions of peasants in China that is still relatively poor by Western standards.

Now, take a look at the United States today. With only a few hundred million people, the US consumes more oil than any other country in the world. China, with four times the population of the US, still does not consume as much natural resources as the US. What if China is to attain the same level of affluence and standard of living as the US? Imagine the amount of natural resources that will be consumed! We are not even sure whether the earth has enough resources to accommodate a nation that is equivalent to four United States in terms of population.

At this point, we still have not yet included Russia, Eastern Europe and India into the picture. Assuming that all these nations are to rise towards the level of the West as China is doing right now, imagine the strain their demands will be imposed on Mother Earth!

It has been said that demand for commodities follow a cyclical pattern. During recessions, the demand for commodities decline and during booms, demand rises. For example, copper is nicknamed the metal with ‘PhD in economics.’ The demand for copper is said to follow the business cycle.

Then there are people like Jimmy Rogers who believe that commodities are now in a upward super-cycle. Of course, there are sceptics to this super-cycle theory because of their underlying conviction that commodity demand still follows a cyclical trend. But what is the underlying belief of the commodity super-cycle theory?

Armed with the understanding from our previous article, Understanding secular vs cyclical, you can see that the rise of China (and India, Russia, etc) that we just described is a secular trend. Thus, the demand for commodities that supports this secular trend must also follow a secular trend too.

But does that automatically mean that commodity prices will go up and up for ever and ever for a very long period of time? From the short-term bubble in metal prices in 2006, it is obvious that there are many speculators who misapplied the commodity super-cycle theory to the extreme. For example, copper prices climbed so rapidly in the short-term that by mid-2006, after having risen in a parabolic path, its prices suffered a major correction.

Now, cast your eyes back to the 1930s in the US. With hindsight, we can easily see that the Great Depression was a traumatic setback in the secular rise of the US in the 20th century. But in the end, the US survived and went on to become a world superpower. The same goes for China. Although we believe China may be facing a major correction down the years (see Can China really ?de-couple? from a US recession?), it does not necessarily mean that her secular rise in the 21st century will come to an end, unless something really drastic happens to plunge China back into the dark ages of the 20th century. As such, her demand commodities will always rise in the long run. The best phrase that explains this point is from our previous article, Understanding secular vs cyclical:

 Sometimes, within a larger secular trend, there are cyclical sub-trends.

As long-term investors, we should not lose sight of this big picture. Sure, commodity prices can even correct 50% in the short to medium term, but do not let the cyclical sub-trends cloud your understanding of the underlying secular trend.

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Understanding secular vs cyclical

Tuesday, March 18th, 2008

One of the most important distinctions that investors have to understand is the difference between secular and cyclical trends. Confusion between the two can result in lost profits or worse still, losses. Before we can give examples of secular and cyclical trends, let us begin with definitions from the Encarta® World English Dictionary:

Secular – occurring only once in the course of an age or century; taking place over an extremely or indefinitely long period of time

Cycle – a sequence of events that is repeated again and again, especially a causal sequence; a period of time between repetitions of an event or phenomenon that occurs regularly

All of us understand the concept of cyclical trends. The four seasons is a fine example- winter comes and goes and it will come back again. For the economy, booms are followed by busts, which are followed by booms again.

Secular trends, by definition, are far less common. An example of a secular trend is the falling trend of film photography. With the advent of digital photography, the usage of film in photography is in terminal decline- it will never rise again and film photography will eventually be consigned to history.

Now, let us introduce more complications into the picture:

  1. Sometimes, within a larger secular trend, there are cyclical sub-trends. For example, due to inflation, house prices will rise in the very long run, keeping place with inflation. But in the short to medium term, there are periods of price inflation and deflation.
  2. The converse is also true- within a cyclical trend, there may be secular sub-trends. For example, when you look at the history of the Chinese civilisation, you will see repeated cycles of dynasties- birth of a dynasty, growth, decay, fall and then birth of a new dynasty again. But within a dynasty, you will find trends that last more than a person’s lifetime, which is secular as far as that person is concerned.
  3. Sometimes, a secular trend is really a secular trend. For example, the decline and ultimate fall of the Roman Empire happened once in history and will not be repeated again.
  4. Sometimes, a cyclical trend is really cyclical. The four seasons is the best example.

How is all these abstract philosophy relevant to an investor?

Well, it is one thing to understand the difference between the two in our heads and another thing to act accordingly. For example, after more than 15 years of non-stop expansion in the Australian economy, there are many people, who through their investment decisions, believe that the business cycle is finally abolished. That explains: Why are the majority so wrong at the same time and in the same ways? To have a good perception of the nature of trends, we have to understand and look at the big picture and have a grasp of time frames that can go beyond our memory and even life-time.

So, in the coming articles, we will apply this understanding in the context of real-life investment decisions.

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Posted in Investor Education | 5 Comments »

Another sign of the business cycle top

Friday, February 23rd, 2007

In our previous article, Where are we in the business cycle?, we explained why we believe that Australia is probably at the peak of the business cycle. We also believe that the United States is also at the peak too. At the top of the business cycle, we will often be bombarded with reports about companies making record profits, even beyond analyst expectations. Consequently, share prices may rise as a result.

Do not be deceived.

In a business cycle peak, company profits as a whole are as good as it can get. If you expect the profit trend to continue and pay a premium price for stocks in anticipation for higher earnings next year, chances are, you will be disappointed.  It is now time to hunker down in your bunker in preparation for the economic downdraft. If you must stay invested in stocks, avoid outright cyclical stocks (see What to avoid at the peak of the business cycle?). Instead, choose companies whose earnings are more robust in the face of an economic slowdown and can survive through the tough times?even then, in such a pessimistic economic environment, even their stock prices will be depressed. Above all, avoid companies who are heavily laden with debt.

Already, we see another big warning sign: More US firms fail to meet Wall St’s earnings forecasts.

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What to avoid at the peak of the business cycle?

Sunday, February 11th, 2007

In our last article, Where are we in the business cycle?, we mentioned that we are now probably at the peak of the business cycle. Given that this is the case, how should that affect our investment decisions?

In Peter Lynch?s book, Beating the Street, he wrote:

When the economy is in the doldrums, the professional money manager begins to think about investing in the cyclicals. The rise and fall of the aluminiums, steels, paper producers, auto manufacturers, chemicals, and airlines from boom to recession and back again is a well-known pattern, as reliable as the seasons.

Therefore, cyclical stocks are the ones in which their earnings follow along with the peaks and troughs of the business cycle.

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ?cheap? (i.e. low P/E ratio) during the peak of the boom. This is because the market will have by then factored in the fall in earnings. The key is to identify which types of businesses are cyclical in nature and avoid them during the peaks? turning point. As Peter Lynch said:

When the P/E ratios of cyclical companies are very low, it?s usually a sign that they are at the end of a prosperous interlude. Unwary investors are holding on to their cyclicals because business is still good and the companies continue to show high earnings, but this will soon change. Smart investors are already selling their shares to avoid the rush.

In Australia, the economy has been expanding for the past 16 years already. This current expansion is twice as long as the previous two expansions. Thus, it is very easy for investors to believe that business cycles no longer apply and become complacent as a result. When we see that the stock market is continuously making record highs, as if the boom time will still continue indefinitely, it is time to become wary.

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