Holding cyclical stocks like metals vs growth stocks like financials: How should I time my entries and exits?

If you buy a cyclical stock when its RoE is high you risk losing significant capital when the cycle turns. The market often makes the mistake of assuming that a company's current ROE will last forever. Take a cyclical business like an aluminum manufacturer where setting up a plant is highly capital-intensive.

In a booming economy the plant runs at full capacity and aluminum prices are high so the company might generate a 20% ROE. The market will price the stock at 2 to 3 times its book value in its exuberance. However in a down cycle the fixed costs remain but sales and prices drop.

In a bad year that ROE can fall to near zero and the market assumes this value destruction will last forever. The stock can easily fall to one-third of its book value. The big money in cyclicals is made by buying them during bad times below book value and selling them during good times.

Growth businesses on the other hand are those where the ROE is structurally increasing. A classic example is a consumer finance company that reimagines its business model and expands its reach. If the ROE structurally shifts from 4% to 20% the business begins growing at 30% annually.

The stock can go from half its book value to 6x book value. The most serious wealth compounding happens when you benefit from both the underlying profit growth and the simultaneous upward re-rating of the valuation multiple.

Disclaimer: All information shared above are strictly for educational and informational purposes only. It should not be construed as financial or investment advice.