Investing

FMC Corp. – A Successful Cyclical Investing Case Study – FMC Corporation (NYSE:FMC)

In April of 2016 I wrote the article “Cyclical Strategy Says Buy FMC” (FMC). The goal of the investment was to achieve a 100% return within five years. Fifteen months later we achieved our goal:

ChartFMC data by YCharts

The original article had a deceptively simple investment approach, but it’s the second (out of five) fully realized cyclical investments from 2016 achieving a 100% return. The first was Twin Disc (TWIN) which achieved this in nine months:

ChartTWIN data by YCharts

(I’ll briefly discuss the other three investments at the end of the article.)

Hopefully, I have your attention. There are big potential gains to be had using a cyclical investment approach. Let’s examine why it’s a solid strategy.

How many history PhDs work on Wall Street?

I don’t have the data to answer that question, but I think it’s reasonable to assume that there are very few relative to the number of physics, economics and mathematics PhDs who work there. This is important for two reasons: The first reason is that in order to outperform the broader stock indexes, an investor must either be faster or different than other investors.

If an investor can obtain and act on information faster than most other investors — either by obtaining important information or by processing trades faster, or a combination of both — then they may be able to use that edge to beat the market. Excluding that approach, in a parimutuel system like the stock market where popularity increases the price of a stock, if one is to outperform an index, then one must have an approach that is different than most other investors, so that stocks can be purchased while the price is low. Which brings us back to the question of “How many history PhDs work on Wall Street?”

My cyclical investment strategy relies in a large part on long-term historical patterns of individual companies and also on the dual conclusions that human beings haven’t changed much throughout history and that our economic system hasn’t changed much in the last 300 years or so (and those changes that have happened can be accounted for, generally understood, and adjustments can be made for them). These conclusions come from reading a lot of history and they are powerful because what they mean is that, given certain conditions, it is reasonable to assume that long-term and medium-term historical cycles will repeat themselves, and if a company’s stock has shown historical cyclicality, if the stock price goes down, then it can be expected to rise again in a similar fashion that it has done in the past. That being said, there are many examples of cyclical stocks that do not recover.

What could hamper a cyclical stock’s expected recovery?

There are six major reasons a cyclical stock may not recover in a timely manner:

1) A fatal flaw in the company’s business model is exposed for the first time

2) The price did not drop enough

3) The stock price experienced a recent super-cyclical high

4) There is a clear and present disruptive threat to the core business

5) The company has high relative debt compared to past down-cycles

6) Management is corrupt or incompetent

Fatal Flaws

With regard to the first reason, often what one sees throughout history is that ‘new’ business models emerge, and sometimes they work for a decade or more, but there are fatal flaws within those models that aren’t initially apparent to many investors until they are exposed. Whether it’s conglomerates in 1960s, internet stocks in the 1990s, or real estate in the 2000s, all the stocks associated with those types of investments would have performed well, then crashed, often never to recover. Just because a stock has done well for 20 years doesn’t mean it’s not hiding a fatal flaw.

For that reason, what want to see with a potential cyclical investment is that it has shown that it can withstand at least three down cycles. If it has done that, it gives me much more confidence that if the company’s business model has a fatal flaw, it will have been exposed already. One caveat to this rule is that it’s also important to check to see if the company’s business model has significantly changed since the last down-cycle. If it has, it may not be a good cyclical investment candidate. FMC has been around since 1883 and withstood just about as many down-cycles as any company on the stock exchange. If its core business had a fatal flaw, I’m confident it would have been exposed by now.

Price

There can be tough calls that a potential investor has to make with regard to any of these reasons, but price is probably the most difficult to discern. Since this is more art than science and we aren’t using a traditional approach of trying to predict future earnings in order to determine value, I use multiple price entry points. I used to use three potential entry points, but now I only use two because I noticed that if the third price point were to happen, then we would probably be in a deep recession and there would be plenty of other stocks available to purchase and I’d likely run out of cash before I could make the third purchase. (The purchase points for FMC at the time were $40, $36, and $31.)

The way I determine the price points is based on the stock’s historical long-term cyclicality. With the case of FMC, it was down over 50% from its cyclical high when I recommended the initial purchase. That means it wouldn’t even have had to make a new high in order to produce a 100% return. That’s important for a methodology that relies on previous prices in order to determine the future value of a stock. I knew that the market had valued FMC over 100% higher in the past. That made it reasonable to assume it could do so again in the future provided a few other conditions were met.

Super-cycles and business model threats

This brings us to reason #3: whether or not the stock had recently experienced a super-cyclical high. Lots of times this can be obvious in retrospect. All one has to do is look at a chart of Intel during the Dot.com boom in the late 1990s and early 2000s to see what a boom or super-cycle looks like. Sixteen years later it has still only recovered to 50% of its previous high.

ChartINTC data by YCharts

Again, this is a judgment call, but FMC looked to me just like a normal cycle and not a super-cycle. I also didn’t see any core threat to FMC’s business model. Certainly nothing that an over 100-year-old company hadn’t gone through before.

Debt

The one issue that may have served to prevent, or at least delay, FMC’s recovery was their debt to equity ratio. It was higher than the previous down cycle, but not as high as the one before that. Ultimately, it wasn’t enough to dissuade me from purchasing the stock. The important part here is that each company be compared to itself. A tobacco company is generally going to have a higher debt ratio than, say, an internet technology company. What I want to know is if the debt ratio is higher now than it has been in past for the same company because what I care about is the cycle repeating in a similar manor.

ChartFMC data by YCharts

Management

Other than price, determining the quality of management is probably the most difficult task of a cyclical investor. Rarely does a company have the same management through three down-cycles, and management is an important factor to consider. That being said, usually I only let management sway my decision to purchase a stock at the very extremes.

I try to place more emphasis on what management is actually doing, and debt and stock issues are the primary measurements I use in that regard unless there are headline producing ethics problems. Often times management can take on debt in order to purchase another company. Usually management overpays for the purchased company at the same time expectations are high. This can often lead to a big sell-off of the stock over the next 2-3 years when earnings expectations are not met. On one hand, management allocated capital poorly and also likely misled investors on how the acquisition would benefit the company. On the other hand, by the time I am considering a stock, the price has already adjusted downward (and perhaps adjusted too much), that the capital allocation mistake (or expectations sales job on investors) on the part of management has often already run its course.

There are also different types of ethics violations management may be guilty of. I generally group these into two categories: those regarding investors and those regarding others (either employees or the public). If there are potential violations regarding investors (like accounting irregularities) then I avoid the stock because of management. Also, if management has clearly lied to shareholders or has been shown to be utterly incompetent, then I avoid the stock because of management. Comments on Seeking Alpha articles are a great way to find out what previous shareholders think of management and along with reading the conference call transcripts, I can very quickly get a good feeling for how management has treated shareholders.

Ethics violations that involve employees of the company or the public I generally don’t let sway me one way or another because those are usually quickly accounted for in the stock price. That means that if there is a management change, or the violations are slowly forgotten by the public, then there is only upside for the stock price and little further downside.

With regard to FMC, I thought management was fine and I didn’t see anything that would dissuade me from buying the stock. There have been other cases that were much more difficult to decide, like the case of Signet Jewelers Limited (SIG), which has historically had sketchy management in my opinion. I didn’t write an article about them because my decision to purchase was very borderline because of management, but I did purchase the stock personally at $73.14 and then made my second purchase at $52.15. I bought twice as many shares at the lower price so the cost basis is now about $59.15. This was the first of my cyclical purchases where the stock reached the second purchase price. So, right now I’m barely in the black:

ChartSIG data by YCharts

Here is the longer term performance of Signet:

ChartSIG data by YCharts

I thought SIG was worth the risk even with marginal management because most of the negatives are likely priced into the stock. (Not to mention an activist investor could become very rich if they could put someone new in charge.) My main point here is that management matters, but not the same way it would matter to a buy-and-hold investor, in which case management would be a paramount consideration like it is for Warren Buffett.

Conclusion

Once company specific research has determined there is a cyclical historical pattern for a stock, then it’s just a matter of determining what sort of issues might prevent that stock from following its cyclical pattern. Often this means there is very little to write about the best cyclical stock picks. You take a hundred-year-old company like Twin Disc with little or no debt, good management, and few immediate risks to their business model, there isn’t a whole lot to say about it except “buy”. For my personal investments that’s good, but it makes it difficult to write articles about good stock ideas. That is why it is important to look back at how previous ideas are performing. The proof is in pudding, as they say. With that said, let’s review my other three published cyclical ideas and see how they are performing.

The first is BorgWarner (BWA). It was my first cyclical investing idea from February 2016.

ChartBWA data by YCharts

The second was Amtech Systems (ASYS), which was published in May of 2016. Amtech almost hit my second ‘buy’ level at $3.90 per share, but bottomed at $3.99.

ChartASYS data by YCharts

And the last was Mylan (MYL) which was published in May of 2016 before the Epi-pen issues. Mylan is a bit of an experiment for the cyclical strategy, it had a good historical pattern, but being a drug company made it questionable how consistent we could expect future patterns to be. Nevertheless, I decided to make the purchase and even though it hasn’t gone anywhere the past year (except perhaps down), it never fell low enough to make a second purchase. (Not yet anyway.) I probably won’t make any more purchases of drug companies using this strategy until I see how this one ultimately pans out. I put a 5 year time horizon on all of these purchases, so we still have over three-and-a-half years for Mylan to meet expectations.

ChartMYL data by YCharts

Out of five published cyclical stock ideas in the past 18 months, two of them have been realized for 100% gains (I have sold my FMC shares), two of them have made significant gains, and one is lower. So, we’re working with an 80% success rate and a significant outperformance of the S&P 500 over the past 18 months, which I’m quite pleased with.

Occasionally I am asked about the future of the company I’m writing about or the internal workings of their business. In short, “What will happen to FMC in the future?” And my answer to this is: I don’t care. Just as I don’t care about all the reasons why the stock price doubled over the past 15 months. Stock prices are social constructions. And social constructions are composed of trillions of thought processes and transactions that I cannot hope to fully understand, much less predict with any accuracy.

My FMC stock has been sold and I won’t look at it again unless the price is low again. If someone wants to buy FMC based on a projection of all its future earnings or based on short term momentum, than that’s fine with me. But that’s not what I do. I’m busy looking for the next cyclical value not the one that has already run its course. It is far more important to examine what has happened in the past, if one wishes to predict the future.

Disclosure: I am/we are long MYL, ASYS, SIG, BWA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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