As long-term investors, value investors must take care to invest only in companies with staying power. Cyclical companies are the most vulnerable to failing as a result of economic shocks, but this does not mean value investors must stay away from cyclical industries. On the contrary, cyclical companies can offer investors some of the most outstanding returns, as general sentiment can sour on entire industries, offering great prices for those with long-term outlooks. The investor must take care, however, to ensure the company is capitalized to survive.
Consider LCA Vision (LCAV) and TLC Vision (TLCV), two companies that use laser-eye surgery to treat vision disorders. Demand for this elective surgery is highly cyclical, ebbing and flowing with consumer confidence. But only one of these companies appears to have understood this dynamic. Consider the cash and debt levels of each of these companies at the end of 2007 (as the recession had not yet hit):
As both companies began to lose money when the recession arrived, LCA Vision's prudence placed it in a position to maintain its competitiveness. TLC Vision, on the other hand, began a battle to stay alive. This week, it lost that battle, finally declaring bankruptcy. It now trades for just 4 cents per share, suggesting shareholders will get approximately nothing in the restructuring.
When investing in cyclical companies, long-term oriented investors must be sure to invest in companies that are not over-leveraged. In good times, however, this is easy to forget; in 2007, TLC Vision issued $75 million of new debt, and bought back $115 million worth of shares. Those who understood the cyclicality of the business were offered a chance to exit, while those who stuck around learnt their lesson.
Disclosure: Author has a long position in shares of LCAV