Friday, August 1, 2008

It's Cyclical...So What?

How cyclical a business is plays a large role in determining how much of its capital should comprise equity and how much should comprise debt.

To illustrate, compare two businesses in different industries. Each have average earnings of $5/share, but for Company A, earnings fluctuate drastically from year to year, while for Company B, earnings are $5/share year in year out. As a result, Company B can afford to take on more debt: since its earnings are stable, it can safely afford to make its interest payments without much doubt. On the other hand, Company A should be capitalized with mostly equity, since it can't be counted on to make its payments when times are bad, and therefore risks defaulting.

The airline industry is a good example of a cyclical industry. When the economy slows, business and personal travel drops. Further exacerbating the airlines' plight is the fact that many of their costs are fixed (e.g. costs of running, leasing and maintaining airplanes), so when revenues drop, profits take a bit hit and often go negative. On the other hand, utilities are relatively stable, as during recessions, you still use the same amount of electricity in your home.

But what about all the industries in between? Sometimes, it's not so easy to determine how cyclical an industry is, which makes it difficult to know if one of your investments has more debt than it should (which risks your investment!).

Bill Conerly, Ph.D, tries to tackle this problem in his book, Businomics. I haven't read it yet, but Bill assures me he discusses the degree of cyclicality of various industries within it. He also showed me a couple of spreadsheets where he's amassed peak to trough sales data for many sub-industries.

Some of these on the spreadsheet (linked above) are intuitive. For example, pleasure boats and pleasure aircraft rank as among the most cyclical, while electricity usage is near the bottom. But some are more difficult to understand. For example, soap and eggs are near the top of the list, while hotels are near the bottom; I would expect these items to be reversed! I asked Bill about some of these peculiarities but I haven't heard back from him in three weeks...Perhaps he's waiting for me to find the answers in his book, which I hope to do soon!


George said...

Did you ever get an answer to your question regarding the spreadsheet?

Saj Karsan said...

Hi George,

No he never got back to me!