Ups and Downs of the Business Cycle

I do not recommend trying to time the market. Once again - I do NOT recommend timing the market. That being said there are benefits to knowing where we are in the business cycle.

From a value perspective what I look for first and foremost is the discount to a company's intrinsic value that their stock is trading at. This card trumps all as the company that leaves you the greatest margin for error should outperform in the long-run. Assuming all else being equal, including the discount to intrinsic value, there are times when I would select one investment over another. Look at today's markets for instance, we are most definitely somewhere around the trough of the business cycle. As the markets begin to improve we can expect a resurgence of inflation as demand returns and rates (which are now at historic lows) revert to the long-run average. At a time like this I would rather hold resource producers that will benefit from commodity price inflation. On the other hand, I would stay away from consumer goods manufacturers who will be susceptible to the rising input prices and may have competitive pressures which will keep them from raising prices to compensate. Financial companies would also perform poorly in an inflationary environment as rates rise and cut into their profits.

As mentioned before, this is only one of the many considerations that would go into comparing one investment option to another. If one company looks like the greater value play and has comparable long term prospects then the short term implications of the business cycle would not play a major part of the decision. This brings me to the next implication for this topic on value investing. When valuing a company it is a good idea to normalize earnings over an entire business cycle. As value investors we take a long term horizon and the value of a company relies in large part on profits that are expected many years into the future. As such, the next few years in the business cycle should not play much importance in the investment decision. It is important to make sure that you don't "anchor" your future expectations on recent boom or bust years. By normalizing profits over an entire business cycle we enable our valuation to take a realistic long-term view of the profits a company can be expected to make without incorporating a bias from the most recent reporting periods. As long term investors we are concerned with the long-term path of the economy and not the short term booms and busts that give rise to great investment opportunities.