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When Should You Buy Cyclical Oil And Gas Stocks?

Cyclical companies – like oil and gas companies – often exhibit revenue changes that can differ greatly from year to year. To that point, take a look at rig builder Keppel Corporation Limited’s (SGX: BN4) historical revenue changes in the table below:

Keppel Corporation Revenue Chart

Source: Keppel Corporation’s earnings report

As you can see, the offshore and marine segment (that’s where most of the oil and gas exposure is for Keppel Corporation) has seen its revenue plummet in 2010 (by 32.5% no less!) and then shoot up in 2012 (by 40%). Now, that’s volatility!

The key to timing cyclical stocks

Timing our entry and exit into a cyclical stock can be very difficult. And for some help on the matter, we might be able to turn to investing legend John Neff.

For those who may not know him, Neff made his name while managing the U.S.-based Windsor fund from 1964 to 1995. In those 31 years, each dollar invested in his fund would have become $56, handily outpacing the return of the S&P 500 (a U.S. market index) by two-to-one.

With a sterling track record, Neff’s views on the subject of investing are certainly worth noting. In Neff’s book John Neff on Investing, he laid out seven principal elements of his investing style and the fifth had dealt with cyclical stocks.

No cyclical exposure without compensating price to earnings multiple

Here’s Neff with his fifth principle:

“[T]he trick with cyclical stocks is to catch them at just the right moment – after one cycle has decimated the stock price but before the improved earnings become apparent for everyone…

…In place of five year growth rates, our estimates of normal earnings guided our analysis. Normal earnings merely represented a best estimate of earnings at more fortuitous points in the business cycle. Never capitalize peak earnings…

…We protected ourselves by purchasing cyclicals only with prospective PE ratios that scraped the bottom.”

Said another way, Neff suggested that investors should not use the highest annual earnings per share that a cyclical company has ever generated to value the firm. Instead, they should be using “normalized” earnings.

Admittedly, estimating “normal earnings” can be more art than science; as such, Neff’s insistence for a low PE ratio (which is also his first investing principle) helps compensate him for the risk taken in a cyclical firm.

Foolish takeaway

To sum up, what Neff has done with cyclical stocks while running the Windsor fund was to first wait for the downturn to arrive, then estimate what a company’s normalised earnings might look like, and then invest only if the price of a cyclical stock gave him a very low PE ratio in relation to its normalised earnings.

Prior to this article, I had shared the first four principles of Neff’s investing approach and for a recap, Neff looks at 1) low PE ratios, 2) solid fundamental business growth, 3) yield protection in the form of a high dividend yield, and 4) a market-beating total return ratio.

There is more to Neff’s approach to come, so stay tuned!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.