To Ride the ‘Cyclicals,’ Know When to Get Off

By now, the response is almost Pavlovian: A few headlines suggest that economic growth is picking up, and another herd of investors rushes headlong into almost any stock connected with industrial America.

The idea is that faster growth will require more production of the basic stuff--chemicals, paper, plastics, metals, etc.--needed to make most of the goods that consumers and businesses will ultimately buy.

Last week, the basic-materials stocks caught recovery fever once again and helped lead the broad market higher. The big winners included paper and lumber giant Georgia-Pacific, up $7.375 to $73.875 for the week; CBI Industries, an industrial gas maker, which jumped $4.125 to $32; and Inland Steel, up $2 to $34.625.

Despite such gains, however, many investors have a surprisingly hard time liking these stocks.

The problem with the “cyclical” stocks, as they’re called (because their fortunes rise and fall with economic swings) is two-fold, according to their doubters.

First, the rally in these stocks isn’t really new; it has been going on, with a few interruptions, for more than two years. So some investors feel it’s too late to get in.

Indeed, Costa Mesa-based money manager Steven Check notes that Morgan Stanley & Co.’s index of 30 cyclical stocks has surged 44% since Jan. 1, 1992, versus a 12% rise in the broad market, as measured by the Standard & Poor’s 500-stock index.

Second, precisely because of their long rally, many industrial stocks’ prices are at high levels relative to the companies’ earnings, which remain depressed in the still-sluggish economy.

Georgia-Pacific stock, for example, now sells for 62 times the $1.20 or so a share the firm is expected to earn this year. The average stock’s price-to-earnings (P-E) ratio, in contrast, is 18 times expected ’93 results.

The cyclical stocks’ high P-Es understandably make many investors nervous. A stratospheric P-E is only justifiable if you expect a company’s earnings to rise dramatically in the near future.

Yet betting on a sharp rebound in industrial companies’ earnings in 1994 requires a long leap of faith about the economy, some Wall Streeters argue. Those skeptics simply don’t believe that global economic growth can improve enough soon to make a meaningful difference for the profits (and P-Es) of cyclical businesses.

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Are those fair points? Absolutely, say industrial companies’ fans. But they still contend that these shares have plenty of room to run in 1994, albeit with the same periodic interruptions that have characterized the rally thus far.

Why put some chips on cyclicals? Here’s what the bulls say:

* Industrial companies’ earnings are definitely getting better. It’s the trend that matters, cyclical fans say, and the industrial trend is up. Third-quarter earnings were surprisingly strong at many of the firms, a sign that these companies are wringing decent results even from a slow economy. Cost cutting and layoffs have helped a lot.

Now, with consumer and business spending clearly picking up steam, this quarter’s earnings should certainly be better than third-quarter results, the bulls say. What’s more, while the conventional wisdom is that the economy will slow again in the first quarter of 1994, some analysts don’t buy it.

“The economy is stronger than what most people think, and if there is going to be a surprise, it will be with a good first quarter,” says David Shulman, a strategist at Salomon Bros. in New York.

Despite the federal income tax hike in 1994 on the wealthiest Americans, “Most people’s taxes are not going up,” Shulman points out. That means consumers’ ability to spend largely won’t be hurt.

* Pricing power is returning, if slowly. A stronger economy helps basic-materials companies sell more goods. Yet volume is only one part of the earnings equation; what the companies also need is the opportunity to boost prices a bit, to recoup some of the price cuts of recent recessionary years.

“There have been no price increases to speak of (in most basic materials) for the past 18 months,” says Tom Reilly, chief investment officer for the value equity group at Putnam Cos. in Boston.

But in recent weeks, one major cyclical industry--the forest products business--has reported surprisingly hefty shipments of linerboard, which is used to make boxes and other containers.

With demand up, key companies have announced modest price increases. On Friday, optimism that those price hikes will stick set off a major rally in paper and lumber stocks.

Likewise, steel stocks have jumped this year on the realization that many steel plants are already running almost full-out. Thus, any boost in demand should mean higher prices--one reason why Value Line Investment Survey now ranks the integrated-steel group (firms like Inland and USX-U.S. Steel) ninth of 98 industry groups for investment potential.

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To be sure, pricing still is a major problem in many cyclical industries, because excess plant capacity exists worldwide. But think about the usual pattern in industry, analysts say: After a recession, as demand grows, pricing first improves for the companies dealing directly with consumers--such as auto makers. As the cycle wears on, pricing power filters down to the companies that make the building blocks of the goods in demand.

* Market psychology is in the cyclicals’ favor. On each sign of good economic news, more investors decide to jump into these stocks. After two years of this, you might assume that everyone who wants to own cyclicals already does. But Mike Wolf, portfolio manager for IDS Advisory in Minneapolis, contends that just the opposite is true. “Most people don’t own them,” he says.

Many large investors abandoned these stocks in the late-1980s, as the economy ebbed. Now, as business improves, there are fewer cyclical names to choose (after the shakeout of the 1990/1991 recession), while investors have more dollars than ever chasing stocks.

The result: The cyclicals have a “scarcity value,” Wolf says--which is why their rallies tend to be so fast and furious.

Yes, these stocks have had a good run; yes, they appear high-priced, and some may be temporarily overpriced.

But Putnam’s Reilly believes that, so long as the economic trend stays positive, investors will be increasingly drawn to the potential of cyclical names, because their promise is open-ended: They can perform as well as the economy will let them.

Which Cyclicals? The market is hungry again for industrial issues, broadly called “cyclical” stocks because their fortunes rise and fall with the economy. But how high can these stocks go from here--and which offer the best profit potential? Here’s a partial list of picks that brokerage Morgan Stanley recently distributed to clients.

1993 Fri. Est. ’94 Stock high/low close EPS* gain AirProducts/Chem. $48 1/2-$37 1/2 $43 5/8 +14% Alco Standard 50 5/8-35 3/4 49 5/8 +29% Burlington Resources 53 7/8-36 1/2 47 +34% Crompton & Knowles 27 1/4-17 5/8 20 1/8 +18% Great Lakes Chem. 84-64 1/2 73 3/8 +21% Phillips Petroleum 37 3/8-24 1/2 31 1/8 +40% Rohm & Haas 62-47 1/4 53 1/4 +19% Sonoco Products 24 7/8-19 3/4 21 1/4 +9% Unocal 32 5/8-23 1/2 27 3/4 +43% Weyerhaeuser 46 1/2-36 1/4 44 3/8 +45% Williams Cos. 31 7/8-17 7/8 27 3/4 +11%

12-month Stock stock target AirProducts/Chem. $48 Alco Standard 63 Burlington Resources 63 Crompton & Knowles 26 Great Lakes Chem. 92 Phillips Petroleum 40 Rohm & Haas 65 Sonoco Products 31 Unocal 35 Weyerhaeuser 65 Williams Cos. 77

* EPS: earnings per share. All stocks trade on NYSE except Sonoco (Nasdaq).

Source: Morgan Stanley