Anatomy of a cyclical

“Rule number one: Most things are cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”  (Howard Marks)

Cyclical Corporation is a world leader in the widget industry. Widgets are a very basic product that is essential to the capital stock of most economies and industries. The demand for and price of widgets exhibits a degree of cyclicality with the ups and downs of the economy. Cyclical Corporation benefits from having many decades of experience in widget manufacturing and as a result has the best and most efficient technology in the industry.

Approximately 15 years ago, Cyclical Corporation began to receive an unusually high level of orders for its widgets from a new customer in a far-away land. Initially, senior management and the stock market investors in Cyclical Corporation did not pay too much attention to this customer. It was believed that such a high level of widget demand from one customer would not be sustained for long. Of course it was great to see the prices of widgets rise, allowing Cyclical Corporation to post healthy growth in its profits.

However, much to everyone’s surprise, this new customer’s demand for widgets, far from falling, continued to grow. After only a few years, the new customer had become Cyclical’s Corporation’s largest.

What’s more, the prices of widgets surged to record highs as the widget industry was unable to keep pace with this new customer’s seemingly insatiable demand. This was great news for Cyclical Corporation’s profits and stock price, which rapidly surged to all-time highs.

The stock market investors began to question why Cyclical Corporation was not expanding its own capacity so that it could grow its profits even more. After all, this was what many of Cyclical Corporation’s competitors were already successfully doing.

The investors believed the widget industry had entered a “New Widget Era” of structurally higher widget demand which meant permanently higher widget prices. The conservatively natured CEO of Cyclical Corporation became frustrated with this constant pressure from his shareholders and decided to retire. Fortunately, his replacement was a firm believer in the “New Widget Era” and he quickly sanctioned a large capacity expansion project for the company.

For a while, this decision appeared a good one, as widget demand and prices continued on their upward trajectory, despite one of the largest recessions in recent history.

The stock market investors were feeling very pleased with themselves having made so much money out of widgets.

Indeed, the stock price of Cyclical Corporation had risen nearly 500% over the preceding decade and the valuation, defined as the price of the shares relative to the invested capital base, had risen to its highest level in Cyclical Corporation’s long history.

But many of the stock market investors argued that Cyclical Corporation’s stock was still significantly undervalued because the company’s profits were growing so fast due to the “New Widget Era” dynamics.

Some even suggested that Cyclical Corporation should change its name because its business model was clearly no longer cyclical at all.

Then something unexpected happened.

The pace of growth of the new customer’s demand for widgets began to slow down. As a result of this, the price of widgets began to fall.

Initially, both the management of Cyclical Corporation and the stock market investors were not too concerned by this. After all, even if the growth in widget demand was a bit slower than expected, the absolute size of this growth was still huge, and easily sufficient to soak up Cyclical Corporation’s ongoing capacity increases.

They reminded themselves that this was the “New Widget Era” which meant widget prices were sure to rebound.

But demand for widgets continued to come in below expectations.

Unfortunately for Cyclical Corporation this happened at precisely the same time as their new widget capacity came on stream. Of course this further depressed prices, which was very bad news for Cyclical Corporation’s profits.

The stock market investors – not renown for their long-term memories – were not happy about this at all. They began to question the credibility of the management.

“Why have you spent so much money on all this expensive new capacity?” they asked.

“The new widget era? We never believed in that. It was obviously not sustainable!”

They demanded management change and management change they got. A new breed of executives joined Cyclical Corporation intent on instilling a culture of cost discipline within the company.

Unfortunately, this was not enough to revive the fortunes of Cyclical Corporation and its now floundering stock price.

Global widget oversupply was so endemic that the price of widgets plunged to levels not seen since the beginning of the “New Widget Era” nearly 15 years previously!

Indeed, the valuation of Cyclical Corporation had fallen to such a low level that even those stock market investors who had never believed in the “New Widget Era” began to wonder whether they should consider buying the shares…


The story of Cyclical Corporation is designed to illustrate how a company’s fundamentals and investor expectations of those fundamentals can both be deeply cyclical. The chart below illustrates how I think about this.

Cyclical Corporation

The bars on the chart show the percentage return on capital (ROCE) of Cyclical Corporation. This is a measure of how fundamentally profitable the company is. You can see that during the boom years the company’s ROCE was as high as 20%. This is far higher than the cost of capital (typically around 8-10%) and so easily justifies expanding capacity. However in the bust years, the ROCE falls to 5-6%.

The arrows show the expectations of the stock market. The shape of these arrows can be inferred from the valuation of Cyclical Corporation. High valuations imply expectations that a high ROCE will be sustained or even rise further for a long period into the future, whilst low valuations imply only a very low or falling ROCE is expected.

Point a) represents the peak of “New Widget Era” hype – when unsustainably high profits were being discounted into perpetuity. In my opinion, it is at this point when investing in cyclical companies is most dangerous because both profitability and market expectations are elevated. What’s more, headline valuations such as price-to-earnings ratios are often not that high (due to the high profitability) which can be very tempting to unsuspecting investors.

When the cycle turns down, this is painful from a profitability perspective as earnings are downgraded. However, the really big money is lost as market expectations for long-term profitability move down from point a) to b) and finally to c). And in contrast, some of the very best investment opportunities occur when the fundamental level of profitability is already very low and market expectations do not anticipate any recovery.

I’m convinced this is the reason the share prices of cyclical companies so often move up down far more than is justified by any change in their underlying intrinsic value.

Over the past decade, I have seen the story of Cyclical Corporation play out in sectors as diverse as housebuilders, construction companies, real estate companies and banks. It is the cyclicality of investor expectations that create the investment opportunity. When the cycle is long, and if there are new factors affecting demand that have not been present before, then investor expectations can become wildly detached from the long-term reality. This is why it is so important to look at cyclical companies over the long-term, making adjustments for exceptionally high or low levels of profitability.

Of course, these things are always easy to see in hindsight. Nevertheless I find this mental model useful. And in the next post I will use it to examine the mining sector.

Matthew Tillett


Author - Matthew Tillett

Matthew Tillett

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