‘Cyclical’ Stocks Show Muscle, but Will It Last?
Alcoa, Caterpillar and Phelps Dodge--are these Rust Belt stocks really capable of leading the market higher?
Long-ignored heavy industry shares have been the market’s stars during the last week, as institutional investors have suddenly bailed out of high-priced “growth” stocks in favor of “cyclical” issues--companies whose fortunes tend to be tied to the economy’s boom and bust cycles.
One catalyst for this lunge toward seemingly every metal, paper and machinery stock is the perception that the worst is over in the Asian economic crisis, and that global economic growth will soon be picking up.
The sheer intensity of the moves in these normally staid stocks suggests the rally has some staying power, analysts said.
Even so, investors should carefully consider whether cyclical stocks are more than short-term trades, some experts said.
“The advances of the last few days in the basic-industry stocks [have] been without a lot of discrimination,” said Tom Van Leeuwen, an analyst at Credit Suisse First Boston. “There’s been a lot of broad investment in the group [that’s] really irrespective of the fundamentals.”
Indeed, sales and earnings for many of the companies haven’t yet rebounded. And even in a rosy economic scenario, industrial stocks’ long-term profit growth is expected to lag that of many other industries.
On Wall Street, the traditional view of cyclicals is that investors should rent them--not own them. In other words, they’re fine for trading, but don’t stick around for the long term.
Goldman, Sachs & Co. seemed to say as much Thursday when it upgraded several cyclicals but designated some of them “trading buys,” not “long-term buys.”
Investing in cyclicals requires a big leap of faith because the best price gains can come well in advance of verifiable improvements in industry fundamentals.
“They move down in advance of bad economic news and move up in advance of a turn-up in earnings,” noted Barry Bannister, an analyst at Legg Mason Wood Walker in Baltimore. “So you really have to buy them in the dark.”
A lot of institutional investors have been doing just that during the last week, pushing the Morgan Stanley index of 30 cyclical stocks up 13.8% since April 9.
In a typical phone call in the last week, “The portfolio manager calls up and says, ‘Clarence, I haven’t talked to you in five years. How are you?’ ” said J. Clarence Morrison, who tracks basic metals companies at Prudential Securities.
Given that the market capitalizations of many cyclical stocks are minuscule compared with the giant technology companies from which many professionals are fleeing, a moderate level of buying can have a big impact on cyclical stocks.
“We’re not a very big sector, and it doesn’t take a lot to push us around,” said Frances Loo, a paper analyst at Warburg Dillon Read.
Vahid Fathi, a metals analyst at ABN Amro in Chicago, argues that the underlying prospects for many companies don’t merit the giddy buying spree.
Aluminum giant Alcoa, for example, now sports a market cap topping $20 billion, as the stock has risen 30% during the last 30 days.
Alcoa’s sales last year were $15.3 billion. That means investors now are paying $1.30 for every $1 in sales. In the recent past, the stock has been considered cheap at 30 cents to 40 cents per $1 in sales, Fathi said. “To me, this represents more a peak valuation than a trough valuation,” he said.
Still, if the global economy is indeed perking up, optimism about earnings this year and in 2000 could continue to drive these stocks higher.
Here’s a look at prospects for several major cyclical sectors:
* Aluminum, copper and other metals: Many metals firms have been slashing costs to try to boost profitability regardless of global market conditions.
Several analysts like Alcoa, which hopes to chop $1.1 billion in expenses by the end of next year.
“As it progresses throughout this program, it will emerge as the premier metal company in the world,” Van Leeuwen said of Alcoa.
He also likes copper producer Phelps Dodge and a small aluminum firm named Easco.
Phelps Dodge, while suffering from depressed copper prices, has a “good cost structure, sound balance sheet and a decent [dividend] yield” of 3.2%, he said. As for Easco, continued strength in the transportation and housing industries, to which it sells many products, bodes well, Van Leeuwen said.
Prudential’s Morrison also is high on Alcoa. The cost-cutting effort means that any increase in pricing power caused by a pickup in aluminum demand would significantly boost profit, he said.
Even after the stock’s surge, “we think Alcoa still looks very attractive,” Morrison said. “When the turn comes, it’s going to be dramatic.”
Outside of aluminum, Morrison likes Cyprus Amax, Stillwater Mining and Freeport-McMoRan Copper & Gold, among others.
But earnings projections for Alcoa demonstrate the uncertainty on Wall Street toward cyclicals.
Analysts’ consensus estimate calls for Alcoa to earn $3.44 a share in 2000, according to Zacks Investment Research. But there is a wide range between the lowest and highest predictions. The lowest projection for 2000 calls for earnings of $2.35, whereas the highest looks for profit to roar ahead to $5.
* Steel: Lower costs, improved efficiency and a drop from last year’s record levels of imports bode well for the industry. But while inventories are down, foreign competition remains fierce.
Kenneth Hoffman, an analyst at Prudential Securities, is high on Bethlehem Steel, which is finishing a lengthy restructuring process. In a report to clients this month, he wrote that the company has sold off underperforming businesses and lowered debt levels.
Also, prices in the spot steel market have been rising since mid-January, he noted.
“We believe that a younger, more aggressive [Bethlehem] could show significant returns over the next several years,” he said.
* Paper and forest products: The outlook for the industry has improved lately amid a continued strong U.S. housing market and expectations that Asian demand will begin to rise. Georgia-Pacific stunned Wall Street on March 18 when it said first-quarter earnings would be far above estimates.
With Georgia-Pacific already up sharply, Warburg’s Loo recommends Bowater and Abitibi-Consolidated, which make newsprint and other papers.
Although North American paper stocks may appear pricey compared with rivals around the world, they’re relative bargains versus many other U.S. market sectors, she said. “The stocks aren’t cheap now, but you kind of have to look at this in context,” Loo said.
* Heavy equipment: Before the Asian crisis hit, developing markets accounted for double-digit annual growth for many machinery makers.
Bannister at Legg Mason Wood Walker favors “bellwether” machinery stocks Caterpillar, which makes earthmoving equipment, and Ingersoll-Rand, a producer of various industrial equipment.
Ingersoll’s management is top-notch, Bannister said, and annual profit should improve 12% to 15% through 2000, he said.
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New Market Leaders?
Analysts expect some basic-industry companies to post noticeably better earnings next year, assuming the global economy picks up steam. If that occurs, the stocks may still be reasonably priced. But if those earnings gains are too optimistic, the shares may already be richly priced, analysts warn. A sampling of industrial stocks and analysts’ mean earnings per share (EPS) estimates for 1999 and 2000, along with the stocks’ price-to-earnings ratios (P/E) based on estimated 2000 EPS.
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Monday Estimated EPS: ’00 Stock Ticker close 1999 2000 P/E Abitibi-Consolidated ABY $10.91 $0.46 $0.94 12 Alcoa AA 54.69 2.55 3.44 16 Bethlehem Steel BS 10.50 0.13 1.21 9 Bowater BOW 48.06 0.91 3.18 15 Caterpillar CAT 61.75 3.31 3.72 17 Cyprus Amax CYM 14.00 -1.14 -0.08 NA Easco ESCO 7.31 0.95 1.15 6 Georgia-Pacific GP 90.19 3.79 5.10 18 Ingersoll-Rand IR 67.50 3.44 3.79 18 Phelps Dodge PD 61.81 0.32 1.92 32 S&P; 500 index SPX 1,289.48 46.91 48.85 26
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NA = not applicable
Sources: Zacks Investment Research, Bloomberg News
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Staff writer Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.
