What it takes to win in cyclicals

Welcome to part two, of our ‘super’ series of the Australian ASX300 excluding the ASX50 stocks. Over the coming weeks, Monique Rooney and I are going to be producing a four-part series that will look at four groups of the market and put them into correlated groups.

1. The innovators,
2. The cyclicals,
3. The financials, and
4. The defensives

In part two, we explore some of the current themes, risks and opportunities, portfolio considerations, and the long-term winners in 'Cyclicals'. You can watch the video by clicking below, or you can read the transcript that follows.

James Abela: Hi, I'm James Abela, the Portfolio Manager for the Australian Future Leaders Fund for Fidelity.

Monique Rooney: Hi, my name is Monique Rooney and I'm an Analyst and an Assistant Portfolio Manager on the Australian Future Leaders Fund.

James: Welcome to the Australian mid and small cap study on the super sector series part two, which is cyclicals.

The cyclicals are really a group where the returns are very volatile, so they are resources, energy, and also industrials. And that's the real cyclicals sub sectors.

Monique: So some of the current themes for cyclicals. It's the recovery in travel post-COVID it's for retailers carrying elevated levels of inventory into potentially a slower consumer environment. It's higher energy prices on the back of Ukraine, Russia, and for materials, it's very much electric vehicles.

James: So opportunities is really about the cyclicality of the earnings profile. So at the low point, you have low earnings, low sentiment, and low return profiles. And at the really high end, when sentiment is really strong, earnings are strong, valuations are strong and the whole markets are really, really positive. So the risks and opportunities are really movement from the low point, right up to the high point. It is a very significant opportunity set and the multiples from here to here can be three to five times, in terms of movement. So they can be very significant.

Monique: Some of the risks for cyclicals? Certainly cost inflation, be it through higher wages, definitely something we're talking about a lot at the moment. So for miners and the mining services company, they typically happen when we've also got high commodity prices, that also feeds into high construction costs. Adding to that at the moment is supply chain issues, as well. And this obviously has implications for developments and returns on those and budgets being overblown. For retailers, a slowing consumer environment. At the moment, we've got high interest rates, higher cost of living, which could potentially lead to a slow down in sales, but retailers carrying elevated levels of inventory might mean greater promotions and so combining these two together, you really can- there's risks that you see that operating into leverage come through for these retail businesses.

James: The portfolio considerations for cyclicals are really about that volatility of the earnings profile and the valuation profile and the return profile. So they tend to all come together. So when they're all very low sentiment, low earnings, it feels like you don't need to be there. A lot of the market just ignores the universe, but when it's at the other end of the spectrum, everyone is interested in it. It's either very hot. It's very, really high valuations, very high earnings and a lot of upgrades. Sentiment is really, really strong and managing a portfolio through that really low point and the high point is really what you need to think about. It's a very significant opportunity set, but it's also where the risk comes from. And you need to think about it because they're very, very correlated when it's negative or when it's very positive.

So long term winners in cyclicals are really those in great market structures. So in resources, it's where there's really high grade minds or high grade metal, or also structural growth metals. That's where you have a really, really nice cycle in resources. Also, very, very good managers in industrial cyclicals. It tends to be those high return businesses where they have good market structures and they're high ROEs and they tend to be really nice compounders. And then there's those cyclical opportunities where the market structure is very, very tight. For example, in airlines or in airports. And they can be really, really good in terms of cyclical upswing, when they do have that upswing in cycle.

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In part one, we looked at Innovators and where we believe they fit within local markets.

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