A primer on investing in cyclical businesses; Update on my dad

I almost never look at or write about cyclical businesses because I don't think I have any advantage predicting cycles. They also tend to be lousy businesses – and I have a strong preference for good (or, better yet, great) ones!

But a good case study caught my eye last week that has some good lessons I'd like to share...

Three years ago, in my January 11, 2023 e-mail, I shared the following thoughts on Titan Machinery (TITN) after seeing the company present at the annual ICR Conference in Orlando. It owns and operates a network of agricultural and construction equipment stores:

[Titan's] earnings have soared thanks to strength in the agricultural sector, which has taken its stock to all-time highs [it closed at $41.75 that day]. Though it's trading at reasonable multiples (0.6 times sales, 7.2 times EBITDA [earnings before interest, taxes, depreciation, and amortization], and 8.8 times trailing earnings), I worry it's cyclical at peak earnings – and I have no insight into whether/when the cycle might turn.

I also don't have any expertise or insight into the agricultural sector. So I decided the company was outside my "circle of competence," put it into my "too hard" bin, and never looked at it again.

But when I saw the CEO was presenting again last week at this year's ICR Conference, I was curious enough to go hear an update...

For some background, the U.S. agricultural sector has been weak in recent years – here's a summary from Google Gemini:

The U.S. agricultural sector, particularly row-crop farming, is experiencing a significant downturn characterized by falling commodity prices from 2022 highs, persistently high production costs (fertilizer, labor, interest), declining farm income, rising debt, increasing bankruptcies, and reduced farmer profitability, leading to financial strain despite strong yields in some areas.

Learning this, I expected Titan's stock to be down... but was shocked to see just how much.

Since I last wrote about it, the stock has crashed by 63% to close at $15.53 yesterday, as you can see in this chart since the company went public in 2007:

This is what the stock of a cyclical company looks like: It has been all over the place but basically flat for nearly two decades.

Not surprisingly, the stock has followed earnings, which have plunged into negative territory due to the downturn in the agricultural sector:

Free cash flow ("FCF"), interestingly, hasn't followed earnings. That's because the company builds inventories (therefore consuming cash) during boom times and shrinks them (generating cash) during downturns – hence the surge in FCF the past two years. This dynamic is good news, as it can allow cyclical companies like Titan to survive downturns:

The company regularly makes a number of small acquisitions over time, with some poorly timed ones at the top of the market in 2022 and 2023 (at least it didn't buy back stock at the peak!):

These acquisitions plus negative cash flow in those two years caused net debt to grow, but it's not at dangerous levels:

In summary, the stock looked cheap three years ago when it was trading at 8.8 times trailing earnings... But we now know that it was, in fact, very overvalued. Anyone who invested then has lost their shirt.

Now, even though it's down 63%, the stock looks expensive. That's because it trades for infinity times earnings – because it has no earnings. It's losing money, and analysts project this to continue for the next five years.

What I'm about to say may seem somewhat counterintuitive, but this is normal for cyclical companies: At the very moment they look cheapest, they're actually most expensive – and vice versa.

Any investor experienced with cyclical stocks (which I'm not!) – airlines, steel, commodities, etc. – will tell you that the best time to buy is when these stocks are bombed out, sentiment is terrible, and analysts are projecting losses as far as the eye can see.

But they're making the classic mistake of projecting the immediate past indefinitely into the future – what Warren Buffett calls "driving with eyes firmly affixed to the rearview mirror."

I would bet a lot of money that the analysts are wrong and Titan will make a profit in at least one of the next five years.

That doesn't mean I'm recommending the stock – as I said, it remains outside my circle of competence.

But I sure think it's a lot more interesting than when I last looked at it three years ago...

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.

P.P.S. Deep thanks to the many readers who sent me thoughts and prayers for my dad, who has been in the hospital in Nairobi, Kenya since he became very weak on Friday.

I immediately took a nonstop flight and arrived Saturday and was happy to see him slowly getting better. But he took an alarming turn for the worse yesterday afternoon and evening – he couldn't stand up or walk unassisted. But this morning he was much better, though still quite weak:

I had to fly home today, so my sister is on her way from Washington, D.C., and will arrive tomorrow. Her son also just flew in (he's doing a scuba program on the coast of Kenya), so we have plenty of family support in place.

I think my dad picked up some sort of bug or virus during our recent trip to South Africa – maybe the "super flu" that's going around the world. If so, it can take weeks for it to pass.

So we just have to keep his spirits up, make sure the doctors and nurses are monitoring him closely (they still haven't figured out what's ailing him), and be patient...