Why I Am Buying Cyclical Stocks

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Despite the whole market looking undervalued right now, one of the most undervalued sectors seems to be cyclical stocks. Global macroeconomic worries have driven these stocks down to such low levels that their valuations are now inconceivable. With companies such as Caterpillar (NYSE: CAT) and Deere & Company (NYSE: DE) trading on as little as 10 times forward earnings; cyclical stocks are starting to look appealing for the value investor.

I think global macroeconomic worries are overdone, with Chinese growth now stabilizing and the Eurozone having made significant progress over the past year. Of course, Chinese growth is still ticking over at around 8% growth a year – a feat not many other countries can maintain. Despite worries over the fiscal cliff situation in the US, global industrial spending is still pushing forward and I believe that the market is not taking into account this global growth.

There are still many strong companies out there who are producing returns.  Take Caterpillar for example, the firm is currently trading on a P/E of slightly below 9, which is only slightly above the ratio it was trading at during the financial crisis of 2008, when the ratio then was just below 8 even though the economy was in a decidedly worse condition. The same can be said for all of the ratios attributed to CAT. The P/B ratio for example is currently 3 compared to 2008 where it was 2.5, while the PEG ratio, calculated by 1 year trailing earnings is down at a historic low of 0.2, as opposed to 0.5 in 2008.

The same trend can be seen in Cliffs Natural Resources .  The majority of Cliffs's revenues come from the extraction of iron ore; however, the company’s share price has not recovered in line with the strength of the iron ore price.


<img src="/media/images/user_14485/cliff-pe_large.png" />

With cliffs P/E currently the same as it was during the credit crunch, I believe it is seriously undervalued, taking into account the strength of the global economy right now compared to the outlook in 08/09.

One of the most undervalued sectors however appears to be gold miners. Although they produce a non-cyclical product, (in fact Gold tends to be negatively correlated with the economic environment), Gold mining companies are still trading at tiny valuations not seen in years. Barrick Gold (NYSE: ABX) for example, has not traded on a foreword P/E this low for more than 10 years! Its P/B comes in at around 1.2 once again the lowest this multiple has been in longer than 10 years. In fact the closest this has been historically was in 2009 when the ratio dropped to 1.7. This trend can be seen across all Gold miners, even considering the price of gold is still roughly where it was a year ago and margins have remained the same.

For less of a cyclical play there is Berkshire’s most recent favorite John Deere.  Again trading on a historic and forward P/E not seen since 2009, the company is less cyclical than most, as it is involved in the ever growing agricultural equipment market. One of the reasons this firm became a holding of Berkshire was due to its strong cash flow and historic shareholder returns, which are still not coming under significant pressure, despite the perceived economic headwinds.

There is also significant possibility in South America, which is still seeing rapid population growth and development. Steel producer Ternium S.A (NYSE: TX) is currently priced at around half book value. The company is instrumental in South American growth and has a strong cash flow and an operating margin. However global worries have set the stock down 50% during 2011. Ternium presents a solid value opportunity with a Graham value of $40, presenting a 100% upside

With valuations at record lows it makes sense to be buying cyclical stocks right now. Global macroeconomic indicators are beginning to stabilize and the worldwide economy is once again regaining its footing.

Many valuations are now worse than the credit crunch in 2008/09, despite the fact that the economic outlook has significantly improved and monetary stimulus is driving forward growth.  However the Eurozone worries are still overshadowing the situation, but these are now mitigated somewhat by the significant steps forward the ECB and the block as a whole has taken.

Overall the world has been through a rough patch over the past few years, but firms do not deserve valuations that are now worse than the crunch we saw in '09. On that view there are some seriously undervalued stocks out there - giving the value investor with a long term outlook a lot of opportunities. 

RupertHargreav owns shares of Caterpillar. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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