Cyclicals and Vibes

Jason’s Random Words

Longtime listener Ken asked a question about cyclicals in this week's mailbag, and I'm not sure I did a great job answering it. My first concern is, how many of our listeners – the smartest podcaster listeners on earth – know exactly what a cyclical stock is? My guess is that it's a higher percentage than most investors, but probably still less than it should be.

And I feel some responsibility for not answering, "what is a cyclical stock" in the podcast. And I think that is really important to understand the answer I actually gave. Call it a smattering of hindsight.

So what exactly is a cyclical? Honestly, every company is cyclical to some degree. Whether it's just the economic cycles of the broader economy, or the niche part of the economy you operate in, the tide ebbs and flows. But when we say cyclical stocks, we mean companies whose business results can vary significantly from one part of the economic cycle to the next. Some notable examples:

• Oil and gas companies

• Steel companies

• Mining and materials companies

• Solar panel makers

• Automakers

• Discretionary goods producers

In short, companies whose business is heavily tied to a commodity that can fluctuate significantly in price or end-market demand, and companies who make expensive, typically long-lived goods that consumers can either keep using for longer or don't need to replace, are cyclical stocks.

To take it another step, oil prices, steel prices, and lithium prices, can change significantly, even as demand for the underlying product itself stays relatively steady or even – in the case of lithium – is still growing at a fast clip. This happens for a lot of reasons, including volatility from traders (who generally are good for commodity markets, providing liquidity and stability), production that grows faster than demand resulting in short-term oversupply, production that falls or grows too slowly resulting in short supply, or large producers (think state-owned oil assets) that intentionally move the markets to their favor.

These are generally relatively mature markets, where it only takes small movements in supply or demand to affect the underlying price in very big ways. And when you make a living on the margins of a commodity price, a small move can result in a big loss or big profit.

But cyclical stocks aren't only in large, mature markets. Lithium and solar panels are two notable examples of cyclical markets, but secular growth. Over the next decade-plus, the shift to increased electrification, driven in part by increased deployment of wind and solar, humanity will require a lot more of both. But it's not going to be an up-and-to-the-right decade. Instead of the nice, linear growth we love to imagine, both industries will go through their share of boom-and-bust periods. This reality broke the teeth of many investors when the solar panel wave crashed on the rocks of China (and others) subsidizing their domestic solar companies, and the cyclical shifts in order demand for the utility-scale deployments that make up three-fourths of solar panel demand.

Say it with me: Secular growth, cyclical industry. 

Tesla is an interesting example of a company that's largely avoided the "cyclical" part of the auto industry, with exceptionally high growth rates for many years. But at some point, when it grows up (will Elon grow up too?) and becomes just another mature automaker, it will be just as subject to the whims of the market as everyone else. A car is something that most people replace because they want to, not because they have to. That's why, when the economy feels weak or actually is weak, car sales fall. They're expensive, and we can keep them longer than we usually do.

So what's an investor to do? I think as a starting point, look at an industry, and its historical return profiles, and decide if it's even worth the trouble. On the one hand, a look at the auto industry's returns over the past three decades would probably have kept plenty of people from buying shares of Tesla (TSLA) and missing a huge winner. But it would also have kept people away from the Rivians (RIVN), Lucids (LCID), Canoos (GOEV), and their EV charging stock cousins like Blink Charging (BLNK) and ChargePoint (CHPT). Even the best (least-worst?) performer of that group is down 87% from its highs as of this writing. Woof.

Sure, I'm now conflating a bubble popping with cyclical stocks. But my cherry-picking is to prove a point. Those EV companies all ran into the realities of higher interest rates on both their capital needs and on the potential buyers who'd be borrowing money to buy their very expensive EVs.

Say it with me: Secular growth, cyclical industry.

What about the mature industries? What should investors do there? There's definitely opportunity. But it requires two things that most investors simply don't have, or don't have both of:

• Industry knowledge

• Trading discipline

It's the rare mature company in a cyclical industry that's worth owning long term. Examples like Nucor (NUE) do exist, but not every industry is built for the sort of expansion and consolidation that it has been able to deliver over the past 40 years. The oil and gas industry is another notable example where we saw a handful of integrated giants expand and consume their way to good returns for investors. And there are plenty of industrial manufacturers who add value to the commodity goods that have been big winners for investors.

But beyond that mere fraction of these tough industries, making money in cyclicals usually means being able to identify when there's a dislocation between the price of the stocks in good companies and where we are in the cycle. In other words, you have to be able to buy that solar panel maker stock or potash stock when it feels like things are only going to get worse, hold it through some extended period of volatility, and then sell it a year or two or four later at a profit. Probably when everyone else is talking about solar stocks or potash stocks as the big trade to get into.

Yeah. Most of us either don't have the knowledge, the mindset, or either, to make money in cyclical stocks. And that's just fine. As Lou Whiteman told us, your portfolio isn't a sports team. You don't have to play the teams you can't beat. You get to pick what goes on your schedule and leverage the things you're good at, and your biggest benefit as an individual investor: Knowing when your season will end, and you'll be living off the results of your on-field success.

Now go buy some ETFs and do something fun with your favorite person. And always remember: I'm a much better investor than Jeff.

Jason

Jeff’s Random Words

In a way, it feels like what I write today doesn’t matter because I assume you’re all gone by now, having been bored to death by Jason’s missive on cyclical stocks. But alas, I write on…

The second half of this week’s podcast was about vibes. I think a lot about vibes and investing because I think it’s another way of looking at the traditional fear vs. greed spectrum of market sentiment. Because I am a weekly stock investor, I have a regular rhythm of looking at my portfolio, as well as my watchlist. Each week I find myself trying to make a decision that’s based on my investing strategy (in short, buy stocks I have high conviction in when they’re acceptably inexpensive) but also how I’m feeling about my portfolio and the market….or…vibes.

Jason and I talk a lot about frameworks over rules. Frameworks make you think, rules tell you what to do. So each week I find myself balancing my strategy and my vibes. To be honest, I don’t know if that’s a good thing or not. I can tell you that sometimes I make my decision based on my process, it’s almost clinical. Other times I buy something because I want to. Because my gut says to. Because the vibes compel me to. I might be an idiot.

Don’t get me wrong. When I follow my gut, I’m still buying a stock I have conviction in, one that I know I want to own. I’m not yelling YOLO and buying the new hot thing. But still, every time I follow my gut I question myself a bit.

I don’t have an answer here, this post will end without resolution. But I have a feeling I’m not the only person who struggles with this, so I wanted to share my thoughts. If this resonates with you, reach out. Leave a comment here in the newsletter, email me at [email protected], or contact me on Twitter (still not calling it X). When do you/should you follow your gut?

Jeff