Cyclicals Surprise Attack?

Earlier in the month, Alcoa was featured as the ‘second worse performing Dow stock in 2011.’ It was almost universally (in research reports by analysts and the press) expected that the financial results would be terrible, as evidenced by this clip from January 9th (Barron’s):

Alcoa (AA) is expected to post a 2-cent loss when it releases fourth quarter earnings results after the closing bell today, but the stock has been riding some momentum this morning. Shares rose 2.3% in a flat market.

In my first book Resources Rock (2004, Insomniac Press) I explained that the most difficult habit to adopt was buying fundamentally ugly stocks when they seem to be down for the count. Cyclicals (which would include Basic Industry, Base Metals, Railroads etc.) have two strikes against them when it comes to analysis – 1) they have skinny margins when they’re doing well, and lose money when they’re not. Oh, and 2) they don’t grow; except by aquisition. It’s tough for a young portfolio manager to get the hang of buying these stocks when things are dismal, and then selling them when everything looks too good to be true.

This news came out January 7th (in the Globe & Mail):

Alcoa makes deep cuts as economy wobbles

“These are difficult steps to improve Alcoa’s competitiveness, preserve and grow shareholder value and protect jobs in the rest of the Alcoa system,” Alcoa chairman Klaus Kleinfeld said after markets closed Thursday.”

So why would this stock bounce over 10% in a few days? It’s as surprising as Secretariat’s comeback at the Kentucky Derby.

Revenues reported turned out to be better than expected, but here’s what I believe is the surprise from the company press release: “Income from continuing operations of $614 million, or $0.55 per share, more than double 2010 results; excluding special items, income from continuing operations of $812 million, or $0.72 per share.” Factor in: “Free cash flow of $656 million” And this stock looks pretty cheap.

It won’t just be this one cyclical stock that will be coming out of a long slump. My own experience has taught me that big cyclical companies only begin to make serious cuts as a last straw. I suppose this is what creates the cyclicality – production cuts long after demand and pricing have fallen, thus creating less supply just when the economy is starting to gather momentum.

A great deal of production capacity in several industries has been removed over the past few years, and capacity is still being removed – which is good news for companies in basic industries and even better news for the stocks.

As I mentioned months ago, the rock bottom consumer confidence at the time was a leading indicator that the U.S. economy in particular would improve (a contrarian indicator). I’ve also relied over the years on the ISM Purchasing Managers’ Production Index as being the most robust (in my view) coincident indicator – although many other published stats of late also suggest that once again, the United States will lead the world out of its slump.

If you wait too long to invest in these volatile sectors, it’s like watching Secretariat at the Belmont Stakes without having placed a bet on the horse.

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He recently authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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