Watch out for "sickly cyclicals"

With economies worldwide slowing and earnings growth at a premium, one of the most marked trends of recent months has been a shift in investor preference for growth stocks at the expense of value according to Crispin Longden, manager of European Assets Trust.

"At turning points in the battle between value and growth it is often difficult for investors to distinguish between the two," said Longden. "In particular, this applies to stocks which are sensitive to swings in the economic cycle."

Longden claims that broker analysts have been extrapolating forward healthy future earnings growth on swathes of cyclical stocks on the back of the last few years of strong growth.

"The result is that while these stocks appear expensive based on historic earnings numbers, they continue to look cheap on future estimates. That is, they are seen as having the characteristics of growth stocks," he explained.

However, Longden believes the case for continued performance from cyclical stocks falls down in two respects.

"First, analysts are wrong to draw from a company's recent earnings history. They should delve back at least to the last cyclical downturn in the early years of this century or even further back given the relative mildness of the last downturn.

"Secondly, record order backlog figures reflect orders which have already been placed not orders pending. They are lagging indicators. In certain cases, a lengthy order book may indicate problems in fulfilling client deliveries in the time schedule demanded, leading to over-run penalties. In other cases, the order might even be cancelled if economic conditions continue to deteriorate".

Longden points out that it is relatively commonplace now to hear of lower levels of customer down-payment or even absence of down-payment on placing of an order.

"This means that the client has less to lose by reining back or pulling out and that the supplier has to contend with a higher cash drain on working capital," he said.

Longden states that a strong signal to buy a cyclical stock is when it appears cheap on historic earnings but expensive on future estimates. This is because the share price will have fallen, bringing down the rating on known historic earnings. Future earnings estimates will have been cut to such an extent that the prospective rating will appear high.

European Assets Trust has sold out of cyclical issues which Longden believes are masquerading as growth stocks. One such example is Outotec, a Finnish provider of specialist technologies and services to the mining and metals processing industries.

"At the price we sold, the shares commanded a valuation of nearly 30x known historic annual earnings but were seemingly valued at below 10x brokers' earnings estimates for 2010. We shall consider investing again in this well-run company when it is trading on 10x historic and 30x prospective earnings," concluded Longden.