In the current economic climate markets are not taking kindly to cyclicals. If solid companies are being pummelled it is because the consumer is too. But in pricing these shares down, are investors being unduly prejudiced?

A simple definition of a cyclical company is one whose sales and earnings are sensitive to the economic backdrop. Examples include financials, industrials and consumer discretionary – all of which are now out of favour.

The prospect of reduced spending has caused the share prices of consumer-facing companies to drop dramatically. We can see this in the performance of FTSE 100 companies. As at the end of August the top 20 largest holdings have delivered a total return of 12.4%.¹ Six of those are natural resources companies, while others, including British American Tobacco and Vodafone, are companies whose services consumers are unlikely to give up even when the budget is tight. The remaining 80 companies, on the other hand, have returned -19.3%.² Detractors in this list include consumer stocks Next and Ocado and industrials Ashtead and Halma.

But it is dangerous to assume that all cyclical stocks will be equally hurt by consumers tightening their belts in the face of recession, increased food costs and astronomical energy prices. Not all cyclicals are equal. A consumer-facing company like Halfords, for example, has a large non-discretionary offering. If my car’s windscreen-wiper is broken, the cost of a replacement is not something I can easily avoid. Yet, YTD, Halford’s share price is down nearly 58%.³

An area which may also be undervalued is industrials. While many industrial companies have been derated, we are seeing little evidence of a demand slowdown in the sector. Management teams are reporting strong order books and are largely confident in their ability to meet, if not exceed, expectations. There are several companies that we believe are in stable enough positions to survive the impending recession – and potentially come out the other side stronger.

Engineering firm IMI is a good example. The company has divisions for precision engineering, critical engineering and hydronic engineering. It manufactures equipment required to facilitate incredibly precise movement – such as the valves for liquified natural gas (LNG) terminals. In recent months, the general attitude towards gas has changed significantly, as its role in the transition to alternative energies has become clearer. The need for the terminals that store and transmit LNG is unlikely to dwindle anytime soon.

Within its hydronic division, IMI builds equipment used for climate control in buildings. The EU is under such huge pressure to reduce emissions – thus the demand for solutions to make buildings more energy efficient remains high.

IMI also serves the food processing industry and healthcare – sectors that should be more resilient to a recession. There are large areas of this business which are likely less sensitive to GDP movement than many people realise.

Additionally, IMI is still going through a cost-saving programme; its most cyclical division will face significant restructuring next year. The cost savings the company will have at a time that cyclical businesses might enter more of a downturn could be a significant benefit. Despite all of this, its share price is down 37% YTD.⁴

Another company that has the potential to benefit from the move towards a more sustainable world is Morgan Advanced Materials (MGAM), a provider of advanced carbon and ceramic materials. It has many niches and serves several different end markets, including energy, defence and healthcare. Its products are technically complex – but the company itself has actually become less complex in recent years. MGAM has decreased its number of operating companies, is well invested and is conservatively managed.

The approach of the new generation of managers is not yet reflected in the way the company is viewed – MGAM’s share price is nearly 20% below where it was five years ago, but in that time the management team have made great progress.⁵

One of its other strengths has previously been a source of criticism. MGAM has around 70 facilities, which is a large number for the size of the company. However, these facilities tend to be in (or close to) the end market – close to where they are making sales. This means that, by luck, MGAM is not greatly exposed to freight costs at a time when they have increased dramatically.

A final company to mention is Surface Transforms – down over 23% in the past year. It operates within the automotive industry, a classic cyclical sector. Surface Transforms is the UK’s sole manufacturer of carbon-ceramic brakes for use in automation and is an industry leader in the development of next-generation carbon-ceramic materials. They have just signed a new contract with a major US manufacturer to export these brakes to the USA. Regardless of the state of the UK economy, this technology is being adopted and Surface Transforms is leading the way. Within industrials we look for innovators, each with qualities likely to help them survive a downturn.

There is little doubt that the next year will be difficult for many cyclical companies, but not all of them will suffer from a recession. As investors, we have to be careful that prejudice does not blind us to opportunities.

 

Laura Foll is co-manager of the Henderson Opportunities Trust and the Lowland Investment Company.

 

¹Bloomberg as at 31 August 2022

²Bloomberg as at 31 August 2022

³https://www.google.com/finance/quote/HFD:LONsa=X&ved=2ahUKEwiP6bevu_H5AhVRS0EAHYl7BSAQ3ecFegQIKBAYwindow=YTD As at 21 Sept 2022

⁴https://www.google.com/finance/quote/IMI:LON?window=YTD As at 21 Sept 2022

⁵https://www.google.com/finance/quote/MGAM:LON?window=5Y as at 31 August 2022