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Commodity-linked sectors, cyclicals and defensives

Lesson 22 · about 9 min

Companies do not all respond to the economy the same way. Some earn more when the economy accelerates and less when it slows; some earn about the same regardless; some earn whatever the price of a commodity lets them. Knowing which kind of company you are looking at tells you which fundamental numbers matter, which ratios lie, and whether the stock is likely to be swimming with or against the macro tide.

Three kinds of company

Type Earnings driven by Examples of sectors Earnings volatility
Cyclical The economic cycle Industrials, autos, airlines, housing, semis, banks High
Defensive Steady demand regardless of cycle Consumer staples, utilities, healthcare, telecom Low
Commodity-linked The price of a commodity Oil and gas, miners, agriculture, shipping Very high

ACME, an industrial selling equipment, is cyclical. Its customers buy more when they are expanding and defer when they are nervous. Its earnings can swing 30% or more across a cycle, and its stock trades that swing in advance.

Cyclicals: earnings that lead the stock, and a stock that leads the earnings

The trap with cyclicals is timing. The stock market anticipates: cyclical stocks usually bottom while earnings are still falling and top while earnings are still rising. So the fundamentals, read naively, give exactly the wrong signal at the turns.

Stage of cycle Earnings Trailing P/E Stock Naive read Correct read
Late expansion Peak, still rising Low (8 to 10) Topping "Cheap, buy" Peak margins; sell
Contraction Falling Rising Falling "Getting expensive" Wait for estimates to bottom
Trough Bottom or loss Very high or n/a Bottoming "Expensive, avoid" Trough earnings; look to buy
Early expansion Rising fast Falling Rising "Still expensive" Operating leverage; hold

ACME's sector at the peak of a cycle might trade at 9 times earnings. That is not cheap. It is the market discounting the decline it can see coming. At the trough, with earnings halved, the same sector trades at 25 times. That is not expensive. It is the market pricing the recovery.

Practical tools for cyclicals:

  • Mid-cycle earnings. Average EPS over the last five to seven years and compute a P/E on that. It removes the peak and trough distortions.
  • Price to sales or EV to sales. Revenue swings less than earnings; the sales multiple is more stable across a cycle.
  • Leading indicators for the sector. Purchasing manager surveys for industrials, housing starts for builders, auto sales for parts suppliers, memory prices for semis. Published monthly, and the market trades them.
  • Operating leverage. From module 2: the incremental margin. High-fixed-cost cyclicals see earnings rise multiples faster than revenue in recovery, and collapse faster in contraction.

Key idea: Cyclicals look cheapest at the top and most expensive at the bottom. Use mid-cycle earnings or sales multiples, and read the sector's leading indicator rather than last quarter's EPS.

Defensives: stability priced in

Defensive companies sell things people buy regardless: food, electricity, medicine. Their earnings move a few percent a year, so their stocks are valued for stability and income, and they behave more like bonds than like cyclicals.

Consequences for a trader:

  • They lag in strong markets and lead in weak ones. A rotation into staples and utilities while the index makes new highs is a classic warning that institutions are getting defensive.
  • They are rate-sensitive in the other direction. A utility yielding 4% is competing with a Treasury yield. When yields rise, utilities fall even though nothing in their business changed.
  • Earnings-day moves are small. A 3% move is large for a staples company. Do not expect drift trades to be worth as much.
  • Valuation matters more. Because growth is low, most of the return is the starting yield and the multiple. A defensive at 28 times earnings has almost no margin for error.

Commodity-linked: the company is a lever on a price

An oil producer's revenue is barrels multiplied by the oil price. It controls the barrels; it does not control the price. The same is true of a copper miner, a grain trader or a shipping company facing charter rates. For these, fundamental analysis of the company is second; analysis of the commodity is first.

The mechanism is operating leverage on the price. Suppose an ACME-sized oil producer has costs of $50 a barrel and produces 40 million barrels a year.

Oil price Revenue Cost Operating profit Change in profit from $70
$60 $2,400M $2,000M $400M −50%
$70 $2,800M $2,000M $800M 0%
$80 $3,200M $2,000M $1,200M +50%

A 14% move in the oil price ($70 to $80) is a 50% move in profit. The stock inherits that leverage, which is why commodity producers have the most violent earnings swings and the lowest "normal" multiples in the market.

What to read for a commodity company:

  • The commodity's price and its direction. The single biggest input. A futures curve in backwardation (near prices above far prices) signals tightness; contango signals surplus.
  • The company's cost per unit. Lower-cost producers survive downturns; high-cost ones become options on the price.
  • Hedging. Many producers sell forward part of their output. A company 70% hedged at $65 does not benefit from $80 oil this year. It is in the filings.
  • Reserves and production trend. Are they replacing what they extract?
  • Balance sheet. Debt plus a commodity collapse is how these companies go bankrupt. Debt/EBITDA at the top of a cycle understates the danger, because EBITDA is at its peak.

Placing ACME

ACME is a mid-cycle cyclical with modest debt. The trader's macro checklist for it:

  1. Which stage of the cycle? The sector's purchasing-manager index has been above 50 (expansion) for fourteen months and is flattening. Late-mid cycle.
  2. Are peers' estimates still rising? Yes, but slower. Consistent with late-mid cycle.
  3. Sector trailing P/E versus its history: 17, near the middle. Not a peak-multiple warning yet.
  4. Rates: rising (previous lesson). Headwind for the sector's customers.

Conclusion: the backdrop is neutral turning cautious. A long swing trade in ACME after a beat-and-raise remains reasonable but deserves a tighter leash than it would in early cycle, and a short in a weak industrial competitor is not fighting the tide.

Try it: Classify five stocks you follow as cyclical, defensive or commodity-linked. For each cyclical, find the sector's leading indicator and its last six readings. For each commodity company, find what percentage of next year's output is hedged.

Recap

  • Cyclicals earn with the economy, defensives earn regardless, commodity companies earn whatever the price allows.
  • Cyclicals look cheapest at the peak and most expensive at the trough; use mid-cycle earnings, sales multiples and sector leading indicators.
  • Defensives are priced for stability, move inversely to rates, and lead when the market gets nervous.
  • Commodity companies are levered bets on the commodity; read the price, the cost per unit, hedging and debt before the company.
  • Place every stock in its type before deciding which ratios and which macro inputs apply.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Margin and leverageA small deposit controlling a much larger position, and the point at which losses trigger a margin call.Position you controlnotional value $100,000your margin deposit: $5,000$100,000 / $5,000 = 20:1 leverageYour deposit absorbs every dollar of loss$5,000$2,500$0Equity leftMARGIN CALLequity has fallen to $2,5000%1%2%2.5%3%4%5%How far the price moves against you
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.
Contango and backwardationTwo futures curves against contract expiry: one rising above spot, one falling below it.The same commodity, priced for delivery at different dates.78.0076.0074.0072.0070.00Futures pricespot+1m+2m+3m+4m+5m+6mMonths until the contract expiresspot price74.00CONTANGOlater contracts cost more than spotBACKWARDATIONlater contracts cost less than spot
Contango and backwardation. A futures curve shows what buyers will pay for delivery in one month, two months and so on. When later contracts cost more than the spot price the curve is in contango; when they cost less it is in backwardation.
An equity curve and its drawdownAn account balance rising over a year, falling from a peak to a trough, then climbing back to the old peak.ACCOUNT EQUITY$20k$12k$8k024681012TIME (MONTHS)PEAK $16,000TROUGH $12,000DRAWDOWN−25%RECOVERY
Equity curve and drawdown. An account balance plotted month by month. The fall from the $16,000 peak to the $12,000 trough is a 25% drawdown, and the shaded area lasts until the balance climbs back to the old peak.