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Stocks  | August 6, 2019

Cyclical stocks can be difficult to value. It’s hard enough to understand a stock that posts steady growth, given factors like competition, management, and industry changes. Stocks subject to big swings based on external factors make that process even tougher.

In theory, cyclical stocks should trade as smoothly as the rest of the market. When the cycle is positive, earnings rise — but the earnings multiple should fall, owing to the fact that profits are nearing or at a peak. In a downturn, the reverse is true: the multiple should expand, as it’s likely better days are ahead at some point.

In practice, of course, that’s not always the case. Investors, like pretty much everyone else, are slow to see macroeconomic changes coming. Markets tend to overreact when news is good — and panic when it isn’t.

At this point, with the U.S. economy reaching its longest-ever expansion last month, cyclical fears are rising. At some point, skeptics worry, the economy will turn. And so “defensive stocks” have gained nicely. Those stocks, including consumer stalwarts like Coca-Cola (NYSE:KO) and Procter & Gamble (NYSE:PG), are less subject to macro forces. Investors who see risk elsewhere in the market — and in bonds trading at or near historically high prices — are flooding into those issues.

In contrast, many cyclicals look cheap. But the key word is “look.” Again, they should be cheap if a recession, or even slower growth, is on the horizon. For investors who believe that’s the case, these are stocks to avoid. For those who see the expansion continuing, these are 10 stocks to buy.

10 Cyclical Stocks: Caterpillar (CAT)

Caterpillar (NYSE:CAT) is one of the quintessential cyclical stocks — and it has proven why over the past decade. The financial crisis hammered Caterpillar: revenue declined a stunning 37% in 2009. EPS, on an adjusted basis, dropped over 60%, to a little over $2 per share. CAT stock fell over 75% in less than a year.

As the world recovered, however, Caterpillar earnings soared. Two key factors drove the growth. What the company itself called a “commodity supercycle,” driven by Chinese demand, sparked growth in excavator sales. The U.S. shale boom added another external tailwind. Revenue doubled over the next three years. Adjusted EPS went from $2.18 to over $9. CAT stock rose over 400%.

As is often the case with cyclical stocks, a bust followed. Revenue declined in each of the next four years — the first time ever, including during the Great Depression. At the lows, CAT had lost half of its value.

Cost-cutting and increased demand led earnings, and the stock, to turn again. From 2016 to 2018, CAT stock tripled. From those highs, however, CAT has steadily pulled back.

Now the stock looks cheap. It trades at a little over 10x 2019 EPS. But as I wrote in June, there’s a ceiling on the stock. Investors are waiting for the cycle to turn and for Caterpillar stock to plunge again.

Again, this is the quintessential cyclical play. There’s not much, if anything, Caterpillar can do at this point to manage global demand. If economies in the West and China stay strong, CAT probably rises. If they fade, it falls. Place your bets accordingly.

Brunswick (BC)

In a changing world, pure cyclical stocks are harder to find. In many cases, there are factors at play beyond simple macro worries. Such is the case with boating stocks like Brunswick(NYSE:BC).

The economy, particularly in the U.S., obviously plays a significant factor in investor sentiment toward the sector. But there are other concerns, most notably a question as to whether younger consumers will buy motorized boats going forward. For reasons including environmental considerations, student loan debt, and lower interest in fishing, it’s possible that new boat demand has already peaked.

That said, recent trading in boating stocks clearly has shown some impact from macro worries. The entire space, which also includes small-caps Malibu Boats (NASDAQ:MBUU), MasterCraft Boat Holdings (NASDAQ:MCFT), and Marine Products (NYSE:MPX), seems dirt-cheap. BC stock trades at less than 10x the low end of its 2020 EPS guidance. MBUU and MCFT have fallen off the table of late and are even cheaper.

When the cycle turns for boating stocks, it turns hard — so “cheap” isn’t enough. But Brunswick is the worldwide leader in the industry, and its growing parts and accessories business provides some protection against a macro turn. BC stock, along with MBUU and MCFT, made my list of cheap growth stocks to buy earlier this year. All three have risk — but all three look intriguing, particularly for investors who think the U.S. economy has more growth ahead.

Ford (F) and General Motors (GM)

In the automotive sector the story is somewhat similar. Like boating stocks, Ford (NYSE:F) and General Motors (NYSE:GM) both look cheap. And bears can, and will, argue that they are cheap for very good reasons.

Here too, there are concerns about near- to mid-term cyclical changes. And there’s the long-term concern that the industry has peaked. In this case, it’s autonomous vehicles that, at least in theory, would result in vastly lower unit sales worldwide.

GM stock has managed to at least trade sideways, while giving investors dividend payments. F stock, meanwhile, touched a nine-year low late last year, and slid back after somewhat disappointing Q2 earnings last month.

Both stocks — at less than 7x forward earnings — can gain, particularly if the economy holds up and the companies can make progress in autonomous and electric vehicles. But the big risk here — and the case for even considering a short of one of these stocks — is if the economy turns before the companies can make that pivot, the Big Two automakers could be in big trouble.

3M (MMM)

Two cyclical factors came in a big way for 3M(NYSE:MMM). A slowdown in Chinese demand and automotive weakness led to a disastrous first quarter report in late April. MMM stock fell 13%, its largest one-day decline since the 1987 stock market crash. It kept falling, losing 27% of its value in less than six weeks.

The fear with 3M stock is that those aren’t the only cyclical aspects of the company’s business. Its industrial and even, if to a lesser extent, its consumer businesses are largely macro-sensitive. And yet MMM isn’t that cheap, trading at 16x forward earnings.

I recommended a month ago that investors sell what was a modest bounce in the stock. I’m not alone: 3M stock has nearly 2% of its float sold short, a big number for a megacap.

Admittedly, a solid Q2 report and a 3% dividend yield might make some investors feel differently. But I still believe there’s more pain ahead — which doesn’t look priced into MMM stock, even at lower levels.

Las Vegas Sands (LVS) and Wynn Resorts (WYNN)

Casino stocks generally have significant macro exposure. That’s doubly true for Las Vegas Sands (NYSE:LVS) and Wynn Resorts(NASDAQ:WYNN).

Their key markets — Las Vegas, Macau, and in LVS’ case Singapore — aren’t just gaming destinations. They’re tourist attractions as well. Across the board, both companies generally attract higher-end customers — the kind that can be more easily lost when a recession hits and businesses go bust.

There are other factors as well, among them fears of another crackdown on the companies’s Macau operations. But it’s cyclical sentiment that has driven both stocks in recent years. Trading generally has been volatile — but sideways on a net basis since the years immediately following the financial crisis.

With another pullback of late thanks to the trade war and rate cut concerns, both stocks became cheaper. LVS, in particular, has an attractive dividend yield above 5%. Better macro news in both the U.S. and China, most notably a trade deal of some kind, could be a catalyst for both stocks to rally again.

Micron Technology (MU)

Micron Technology (NASDAQ:MU) admittedly is a bit different than the other stocks on this list. MU stock isn’t a cyclical stock in the sense that it’s so directly impacted by the broader economy. Rather, supply and demand dynamics in its NAND and DRAM memory markets create sector-specific cycles.

But those cycles are enormous. Micron actually lost $1 per share in fiscal 2012. In fiscal 2018, it earned nearly $12 on an adjusted basis. In FY20, analysts expect those profits will plunge to under $3.

But those cycles are enormous. Micron actually lost $1 per share in fiscal 2012. In fiscal 2018, it earned nearly $12 on an adjusted basis. In FY20, analysts expect those profits will plunge to under $3.

That volatility has continued of late: MU soared after an earnings beat in late June. It’s starting to pull back again, however, and for what I believe is good reason.

Part of the issue is that MU stock looked absurdly cheap last year, trading at times below 4x earnings. That’s no longer the case, at least on a forward basis: the P/E multiple based on FY20 estimates is about 17x. Again, cyclical stocks should see their multiples expand near the bottom. But the question for Micron is whether this truly is a bottom — and whether the 2018 peak was just a one-off confluence of factors that are unlikely to repeat.

Lennar (LEN) and D.R. Horton (DHI)

Home builders Lennar (NYSE:LEN) and D.R. Horton (NYSE:DHI) are unsurprisingly sensitive to the U.S. economic cycle. Both stocks fell steadily throughout 2018 as cyclical worries made their way into housing-related stocks. Both have rallied this year, with LEN gaining 22% and DHI climbing by almost one-third.

At the moment, both stocks look like straight bets on U.S. housing — and there’s a reason to take either side of the trade. If the economy turns, both companies and stocks are going to struggle. But there’s also an increasing supply problem with housing in the U.S. in part due to a labor shortage. That suggests that Lennar and D.R. Horton have pent-up demand left to fill, which could keep profits rising for years to come barring an outright recession.

At reasonable multiples — LEN trades at 8x+ EPS, and DHI 10x+ — both stocks will rise if their market outperforms expectations. But, as seen last year, it doesn’t take much more than a change in sentiment to undercut the group, even when the stocks are cheap to begin with.

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