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The Problem with Cyduality
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The industrial materials sector includes abroad array of companies, which make everything from the fragrances used in soap to bulldozers and heat-seeking missiles. The general business model is simple: Industrial materials companies buy raw materials and facilities to produce the inputs and machinery that other firms use to meet their customers' expected demand for goods. This is a classic Old Economy sector, because it consists of companies that make tangible goods.

We divide industrial materials into two groups: (i) basic materials such as commodity steel, aluminum, and chemicals and (2) value-added goods such as electrical equipment, heavy machinery, and some specialty chemicals. The primary difference is that commodity producers have little or no influence on the price of the products they produce. Makers of value-added industrial materials, on the other hand, may be specialized enough or improve a customer's business enough for the manufacturer to share part of that benefit in the form of a premium price

From an investor's point of view, these companies are the classics. All the traditional rules apply, and textbook indicators such as asset turnover and debt ratios can reveal a great deal about the companies' performance and fi­nancial health. But, because most of these companies supply industry with inputs, they are closely tied to the economic cycle and most firms' shares tend to create little value for buy-and-hold investors between cycle peaks. To make matters worse, many segments of the industrial economy—particularly commodity producers—face destructive long-term price deflation. Low-cost competition and excess capacity can easily overwhelm any growth in demand, which is often in the low single digits at best.

The general idea of the business cycle is that economic growth is followed by an eventual slowdown or a recession, then a recovery, and then the cycle starts anew. When the economy is firing on all cylinders, profits and competition intensify, as does demand for economic inputs such as raw materials and labor, "which in turn become more expensive. In this environment, interest rates often rise because capital is in demand. Increased operating expenses, interest payments, and competition erode businesses' margins and lead businesses to reduce capacity. As businesses cut costs by investing less and laying off employees, inventories and prices decline. Once the excesses are "worked off, expansion can begin again.

Industrial materials producers often find themselves at the business end of the economic cycle bullwhip, "where a small motion at the other end can cause great gyrations (see Figure 24.1). For example, when the economy is expanding, International Paper (IP) can harvest wood and run its mills at full capacity because demand for its lumber and bleach-board paper runs high. When the companies that use IP's products see consumer spending dry up, however, orders plunge. Thus, IP's sales magnify changes in GDP growth: When GDP growth rises, IP's revenue growth soars; when GDP growth contracts, IP's sales growth plummets.

Makers of big-ticket industrial items, such as Caterpillar, which manufactures off-road trucks and earthmoving equipment, or Deere & Co., a maker of agricultural equipment, can face another kind of cyclicality. These producers operate in mature industries, where demand is driven largely by replacement of

older products. In times of economic uncertainty, builders and farmers can exercise some discretion in the timing of purchases. If their own prospects are uncertain, they can delay buying new equipment until better times.

Dealing with demand swings can be very difficult for industrial com­panies. Most of them manufacture commodity products with little pricing power, so profit margins tend to be very slim—around 5 percent on average. Companies compensate by dedicating themselves to achieving high production volumes, which often lead to high fixed costs for manufacturing facilities. When demand is strong, they can make a solid profit because incremental production beyond the breakeven point comes with a high margin (a concept known as operating leverage). But when demand falls, fixed costs become a burden that can threaten the very survival of a business. Only the most efficient producer, with the lowest fixed cost base in relation to sales volume, can remain profitable through a downturn.

Industrial materials companies also use product diversification to di­minish the impact of cyclicahty. Many, including Caterpillar and General Electric (GE), have large financing subsidiaries that make loans to their corporate customers as well as consumers. In many cases, these subsidiaries account for a large proportion of the corporation's value. To temper their overall cyclicahty, companies can also diversify among products tied to longer and shorter cycles "within the economy. For example, to complement its long-cycle businesses such as power generating equipment, GE has also diversified into short-cycle businesses, such as the NBC television network. General Electric also generates recurring revenue and profits from specialized servicing contracts for complex equipment that is already in use, such as jet engines used by airlines.

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