Why Cheap Stocks Are Often Expensive and Expensive Stocks Are Often Cheap
What Are Cyclical Valuations
Cyclical valuations refer to the way stocks in cyclical industries behave differently from steady compounders. In sectors such as metals, cement, shipping, auto, real estate, or commodities, earnings fluctuate sharply depending on economic cycles, demand supply balance, and pricing power.
The key insight is this. In cyclical businesses, earnings peak when conditions are best and collapse when conditions reverse. Traditional valuation metrics like Price to Earnings can become misleading during these phases.
At peak earnings, P/E ratios often look very low because profits are temporarily inflated. At trough earnings, P/E ratios appear extremely high or meaningless because profits are depressed. This creates a valuation illusion.
Why Traditional P/E Fails in Cycles
Imagine a steel company earning ₹100 per share at the top of the cycle. If the stock trades at ₹600, the P/E is 6 times. It looks cheap.
Now assume earnings fall to ₹20 in a downturn. If the stock corrects to ₹400, the P/E becomes 20 times. It suddenly looks expensive.
But economically, the stock was most risky at ₹600 during peak profitability and relatively safer at ₹400 near the trough. This is why cyclical investing requires a different lens.
How to Adjust for Cyclicality
The solution is to normalise earnings and returns across a full cycle.
1. Cycle Adjusted Earnings
Instead of using last year’s earnings, calculate average earnings over 5 to 10 years covering both upcycles and downcycles.
Normalised EPS equals Average Earnings Across the Cycle
Then calculate P/E using this normalised number.
For example, if average EPS over a full cycle is ₹50 and the stock trades at ₹500, the cycle adjusted P/E is 10 times, not 6 or 20.
2. Cycle Adjusted ROE
ROE spikes during boom periods and collapses during downturns. To adjust:
Normalised ROE equals Average Net Profit Over Cycle divided by Average Equity Over Cycle
This gives a realistic view of capital efficiency across environments. A commodity company showing 30 percent ROE at peak may only generate 12 percent across a full cycle.
3. Adjusting Book Value
For asset heavy cyclical businesses, book value can fluctuate due to impairments or revaluations. Analysts often smooth book value by removing one time gains or losses and adjusting for realistic asset productivity.
Another approach is using Price to Book relative to mid cycle ROE.
Fair P/B approximately equals Normalised ROE divided by Cost of Equity
If a business earns 12 percent normalised ROE and cost of equity is 12 percent, fair P/B is roughly 1 times. Paying 3 times book for such a business may not be justified.
Where Cyclical Valuation Matters Most
Industries such as metals, oil and gas, shipping, capital goods, and auto ancillaries exhibit high operating leverage. Small changes in pricing create large swings in profits. In these sectors, valuation must be based on mid cycle assumptions, not peak margins.
Cyclical stocks are typically bought when earnings are depressed but balance sheets are strong, and sold when profitability looks abnormally strong.
Key Indicators to Watch
- Capacity utilisation trends
- Commodity price cycles
- Industry supply additions
- Balance sheet leverage
- Cash flow generation during downturns
A true cyclical winner is one that survives downturns without diluting equity or overleveraging.
Conclusion
Cyclical valuations demand counterintuitive thinking. Low P/E at peak earnings often signals danger. High P/E during downturns may indicate opportunity.
The key is to anchor valuation to mid cycle earnings and sustainable returns on capital rather than current profits. Investors who understand cyclicality do not chase numbers. They study where the industry stands in its cycle and price businesses accordingly. Over time, this discipline prevents buying into euphoria and selling into pessimism.
