A Valuable Lesson about Cyclical Trends

 

Today, I’d like to talk to you about cyclical trends, and why long-term, buy-and-hold investors should avoid them. But first, a story about Australia …

The Story of Eli Broad

My wife and I recently returned from a long trip to Australia (where a niece married an Aussie) and New Zealand, a trip that included waypoints in Los Angeles and Tahiti.

Happily, the Cabot team performed perfectly in my absence—which means I can plan more trips for the future.

Plus, I got some great ideas for stories, the first of which I’ll share with you today.

It starts with our visit to The Broad, a museum in Los Angeles whose name rhymes with “road” — or “rode”— or “rowed.”

The museum, which opened last September in a revolutionary new building that will surely spawn imitators, houses the contemporary art collection of Los Angeles businessman/philanthropist Eli Broad and his wife Edythe.

It’s worth a visit, not least because admission is free.

And why is it free? Because everything is paid for with Eli and Edythe’s money.

And where did that money come from?

Mainly, Eli earned it.

His first big business achievement began in 1957, when he and Edythe’s cousin’s husband Donald Kaufman joined together to begin building and selling houses in the fast-growing suburbs of Detroit. Within two years, they’d built and sold 600 homes.

In 1961, their company, Kaufman and Broad, went public on the American Stock Exchange. In 1969, it was the first homebuilder listed on the New York Stock Exchange. And in 1974, Broad stepped down as CEO.

But Eli Broad wasn’t finished.

In 1971, he had acquired Sun Life Insurance Company of America, and over the decades, he grew it, transformed it into SunAmerica, and in 1999, sold the company to American International Group for $18 billion.

Last year, Forbes estimated his worth at $7.4 billion, so he can afford to open up his museum for free.

Kaufman and Broad (KB)

My special interest in Mr. Broad comes from the fact that his company, Kaufman and Broad (KB), was one of the eight stocks recommend in the very first issue of Cabot Growth Investor (originally named Cabot Market Letter), which my father published way back in October 1970. 

KB was trading at 37 3/8 at the time. (Fractions were the order of the day back then; decimalization didn’t debut until 2000.) The company had announced earnings growth of 36% in its latest quarter. And its stock was strong—but fickle, because it was living off a cyclical trend.

By the time my father recommended selling in September 1972, nearly two years later (the stock’s performance was faltering), KB had brought followers of his advice a profit of 110%. (For the record, the stock had split 2-for-1, and was then trading at 39 1/8.)

Now, if you’d been a Cabot subscriber back then, you might have been tempted to stay with the stock. I know how people feel when they get a profit of more than 100% in a stock; they tend to get a little attached to it.

But if you had held on, look what you would have been faced with.

No one knew it in 1972, but there was a recession coming, and it hit homebuilders—of which Kaufman and Broad was the largest—quite hard. From the point Cabot recommended selling, the stock fell for nearly two years, all the way to a low of 2 and a quarter, a drop of 94%.

Now, Kaufman and Broad didn’t die, even though earnings disappeared until mid-1976. The company survived, and today it’s known as KB Home (KBH), has revenues of $3 billion, and is valued at roughly $1.23 billion.

So what would your investment be worth if you hadn’t taken that 110% profit in 1972, and had simply held on? By my rough calculations, which ignore the reorganization in 1986 that spun off the insurance division (which became SunAmerica), if you had put $1,000 in the stock back in 1970 and simply left it, today that investment would be worth $6,432—which is not so impressive. In fact, that’s a compound annual growth rate of just 4.18%.

That low return is not so much because KB has been a poorly run company—it hasn’t—but because the twin cyclical trends of the homebuilding market and the stock market have put some wild swings in the stock.

The original 1970 buy was just 18 months before the stock’s peak, which preceded that huge waterfall decline that took decades to recover from, and today the stock (and industry) are still working to bounce back from the implosion of the mortgage and housing industries that saw revenues at KB Home shrink from $9.4 billion in 2006 to $1.3 billion in 2011.

In that decline, the stock lost 94% of its value!

Now, it’s very likely that KBH will be a fine growth stock once again, whenever the next bull market in housing stocks rolls along. 

But that’s not likely to be for a while, given that the recent crash is so fresh in our minds. Investors in the sector remain risk averse.

In the meantime, the story provides what I think is a valuable lesson about investing in cyclical sectors (automobiles, housing, airlines, industrial commodities) vs. non-cyclical sectors (toothpaste, soap, tobacco, electricity, insurance).

Cyclical trends never last (hence the name), which means the sectors that are at the mercy of those cyclical trends seldom make good buy-and-hold investments, regardless of how capable management is, while non-cyclicals are often good buy-and-hold investments, particularly if management is above-average. 

If you’d like specific advice on investing in the latter—well-run steady growers like Clorox (CLX) and Procter and Gamble (PG)—you can get excellent advice from Cabot Dividend Investor, which will help you build a top-performing portfolio supplemented by steady dividend payments. Today, analyst Chloe Lutts Jensen’s portfolios show an average total return of 20% and an average yield of 3.5%. Get more details here.

Alternatively, if you’d like expert advice on going where the action is now, so you can aim for 100% profits in a year or two, your best bet is Cabot Top Ten Trader, which every week provides you with a detailed look at the top ten growth and momentum opportunities. Ace growth analyst Mike Cintolo is your guide here, and right now, his list of stocks includes such hot stocks as SolarEdge (SEDG), Five Below (FIVE) and Elli Mae (ELLI). Details here.

Sincerely, 

Timothy Lutts
Chief Analyst, Cabot Stock of the Month
and Publisher of Cabot Wealth Advisory


Timothy Lutts can be found on Google Plus.

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