Conventional wisdom says: Buy low P/E stocks and sell them when their P/E is high. But there are stocks where you do the reverse. To make money in them, you must buy when their P/E is high and sell when the P/E is low. Which are these stocks? Let’s find out. A 🧵
The idea was made famous by Peter Lynch. According to him, investors need to approach investing in cyclical stocks differently. These are companies whose revenues and profits are closely tied to the state of the economy. Examples: Autos, hotels, and metals
Take Tata Steel as an example. When the economy grows, steel demand rises and profits soar. So, companies like Tata Steel make a killing. In downturns, metal prices fall, revenues shrink and earnings crash. This earnings swing is what makes cyclicals tricky.
Between May 2020 and October 2021, steel prices rose considerably. Tata Steel’s profits? Mar 2020: ₹1,174 Cr Mar 2022: ₹41,749 Cr That’s the impact of a boom cycle. But it doesn’t last forever.
Now, let’s talk about why P/E works differently for cyclicals like Tata Steel. P/E = Price/Earnings per share Say the stock price of a company is Rs 100 and the EPS is Rs 20. The P/E will be 5. What happens if EPS increases to Rs 40? 👇
The P/E will fall, as the denominator is now bigger. So, the P/E will be 2.5. You see what happened here? Higher P/E is due to lower EPS. Lower P/E implies higher earnings. That’s what happens in cyclicals. Earnings rise faster than the stock price, making it look cheaper.
This is why Peter Lynch says: With cyclicals: ✅ Buy when P/E is high (earnings are depressed, likely to rise) ❌ Don’t buy when P/E is low (earnings are peaking, likely to fall)
Let’s get back to Tata Steel. In Apr 2021, it looked expensive at 49.5 P/E. Buying then & exiting in May 2022, when P/E fell, yielded an 11.8% return. But if you bought it in May 2022 (P/E 3.5) and sold it in July 2023 (P/E 71.8), you would have got just 5% returns.
There is one thing worth highlighting. This trend may not hold in bearish markets. For example, after Sep 2024, markets corrected significantly. During such a time, all stocks are down, including cyclicals.
Wrap Up Cyclicals don’t obey textbook P/E logic. You have to see where you are in the cycle. And then decide if that “expensive” stock is actually a comeback story waiting to happen. Don’t let surface-level valuation metrics fool you.
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