Cycle Analysis

Maybe if we called them “industrial dominators,” or “manufacturing masters,” you’d buy more of them. What if economists called them “money-coining machines”? That’d get your attention. Instead, we on Wall Street call them cyclicals, a decidedly unsexy term that lately has been sending investors running in the opposite direction. We leap for the Mercks or the Microsofts but forget entirely about this class of stocks – even though they are about to explode.

So let’s talk about them now, before you miss an opportunity to make serious money. These dormant stocks are going to wake up in two weeks, and you’ll want them in your portfolio. But first, I have to get a bias out of the closet, one that I’ve harbored ever since my stock-picking days at Goldman Sachs, back before I ran my hedge fund. I always hated the idea of industrial stocks, dreary names like Bethlehem Steel, Navistar, and Alcan Aluminum. They almost always serve as an anchor – a leaden, rusty, barnacled dead weight – dragging on an otherwise decent selection of growth-technology and health-care stocks.

However, I know perfectly well I can make money with them every five or six years, during those moments when the real U.S. economy, the firmament these companies play in, runs out of gas, which triggers the following familiar scenario. First, the Federal Reserve steps in and begins to lower interest rates. Early on, the rate tonic doesn’t seem to do much, because short-term rates were so high to begin with that they have to fall even further before the antidote reaches the traditional smokestack industries. The Federal Reserve knows this, but it doesn’t want to cause a panic by slashing rates so fast that the markets say, “Wow, things must be even worse than we thought.” The Fed wants to boost confidence, not shatter it.

That’s where we are right now. The Fed is on the verge of sawing rates down even further, to the low single digits, after its first half-point hacking in early January. And when it makes its move, perhaps as soon as this week, you have to hold your nose, grit your teeth, and get long these has-beens because they are about to produce phenomenal returns. If I can make a botanical analogy for a second, these are the desert flowers that fail to come up year after year; then, one season, after we get a massive amount of rain, the swollen buds explode.

Most people have forgotten about these companies, as they’ve been underperforming since 1995. You probably even own some in a mutual fund or buried in an IRA and don’t know it, like Molière’s Bourgeois Gentleman, who discovers he’s been speaking “prose” all along.

But I have always had this fetish for cyclicals, because I made so much darned money on them the last time the rains came. I stay on top of them through thin and thinner because when the exquisite moment happens, I want to corner the gains. And don’t worry; the gains will be there because I will let you in on one of Wall Street’s dopier obsessions: the need for “super compares.” In English, that means that portfolio managers salivate over the stocks of companies that report giant increases in earnings year after year. The larger the increase, the larger the spike in stock price when it gets reported. Drug, food, and even tech companies won’t show gargantuan increases this year. Frankly, soft consumer-goods stocks, like Pfizer and Philip Morris, just show consistently higher earnings. Tech, because of the worldwide information-technology slowdown, may barely eke out gains in the coming months. But the cyclicals, once the Fed cuts rates, could show the kind of monster improvement that money managers go googly-eyed for.

Which of these manufacturing masters will coin the most change for you? I don’t like to overthink this: Stick with the companies that are good at what they do, dominate their markets, and have management that recognizes the boom that’s about to materialize now that the Fed wants one to happen.

Let’s start with the Dow Jones Industrials. Alcoa took advantage of the past five years of aluminum gloom to buy just about every company that mattered in the aluminum market that wasn’t Russian. I don’t like current management as much as I liked the regime of Paul O’Neill, who bolted to take over the Treasury Department. He’s a great guy, and I am a card-carrying Democrat! O’Neill, however, put in place a business whose stock price could double over the course of the coming Federal Reserve eases.

Or how about International Paper. Here’s a stock that’s been doing nothing. That’s about to change, because John Dillon, another smart guy, went on a buying spree rivaling even Alcoa’s. IP, as everyone knows, controls whole grades of paper right now, which means it at last has some pricing flexibility. When the world’s economy snaps to, IP will be making money hand over fist. Added bonus: The euro, which is the currency that IP’s competitors price their goods with, has headed up while the dollar has headed down. That gives IP the worldwide price advantage it needs to stop those pesky Swedes from taking market share. Remember this formula: Low-cost producer with low-price currency equals higher stock price.

Or how about 3M? Minnesota Mining and Manufacturing quietly produces just about everything industrial from its cloistered headquarters in St. Paul. Well, look out; they are about to blow the doors off because this inbred company just brought in W. James McNerney Jr., one of Jack Welch’s logical heirs who didn’t get the top GE job. McNerney wants to prove to the world that he would have been the best choice. And his proving ground is going to be MMM. It would have been enough to buy MMM with just McNerney at the helm. However, with a Fed ease providing a wind at his back, can you afford not to own MMM? Didn’t think so.

Or how about United Technologies? Don’t let the “technologies” fool you; they bend enough metal at this company to warrant the cyclical, oops, manufacturing master, title. David George, the steel-trap top man, has seen plenty of business cycles and knows how to take advantage of the booster shot we are about to get. Some of the businesses of UTX, the only moniker anyone on Wall Street knows it as, are already in full flower, courtesy of the boom in aerospace. Construction and military have been in the doldrums, though, and you can bet those conditions are about to change dramatically.

Finally, I favor Schlumberger. You need some energy exposure for when economies snap back, and this stock has just been crushed because of a couple of weeks of unseasonably warm weather. Sometimes the planets get in alignment for industrial and energy America. This period will be one of them, given the cast of characters in Washington right now. How can you not take advantage and ignore this oil-services play right now?

I don’t want to give you any more because, once the easings are done working through the economy, probably by next winter, you are going to have to extricate yourself from these desert flowers before they wilt and go back into dormancy. Stocks, unlike Borrego Springs blossoms, don’t look so good pressed and preserved in a scrapbook. You want to be in next week and out next year. We’ll catch up with them again, though, but let’s hope not within the next five years.
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Cycle Analysis