Cyclicality commodity cycles

Perfect capital markets should see through the cycle and the reaction of valuations to purely cyclical fluctuations in the industry return on capital should be insignificant. To examine this, we again compared the actual valuation level to a fundamental predicted valuation level for commodity chemical companies. To pinpoint the effects of cyclicality, however, we used a slightly different approach. As we wanted to evaluate capital market expectations, we compared the actual valuation level with a fundamental valuation level based on perfect foresight , i.e., assuming that the capital market knew the actual development of the key value drivers for the next 8 years and evaluated this information in line with its implied fundamental value creation.4 Furthermore, we used a capital structure-adjusted market-to-book ratio instead of an earnings-based metric for the valuation level. 

The first finding for the commodity segment is that size does matter. Larger companies had less cyclical (though not higher) returns on invested capital, and the less cydical returns correlated, albeit mildly, with higher total returns to shareholders. These companies were not only able to cut their production costs, but also had suffidendy diversified offerings - and therefore sufficiently stable cash flows - to weather cycles for individual products. 

However, if chemicals are irredeemably cyclical, does that make commodity chemicals an unattractive business In our view, the key is to look beyond individual cycles, at the long-term profitability of the sector. This reveals a perhaps surprising judgment, in view of conventional wisdom about the sector s unattractiveness commodity chemicals have earned returns above their weighted average cost of capital (WACC) across a number of cycles, making it very different and a much better performer than most other commodity sectors. 

Many commodity prices exhibit cyclic behavior due to the investment cycle, so in some cases nonlinear models can be used, as in Figure 6.4c. Unfortunately, both the amplitude and the frequency of the price peaks usually vary somewhat erratically, making it difficult to fit the cyclic price behavior with simple wave models or even advanced Fourier transform methods. 

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