Cyclicality - resources needed

March 25, 2022

by a searcher from North Carolina State University in Sykesville, MD 21784, USA

I understand why one would want to avoid cyclicality and seasonality when planning an LBO, especially with a service company with mostly intangible assets. That being both hard to finance and dangerous to buy at the top of the cycle. What isn't clear to me is how to determine if a business is cyclical? Does anyone know of any resources to try to determine this? Further, does anyone have any resources to try to determine where in the cycle an industry is?

Basically, I am seeing many businesses with revenue either trending up significantly or down significantly, and the rationale for these changes is unclear. So far of the ones I have dug into, it does not seem to be the owner driving these trends but the industry. I can guess, for instance, with a pool construction company doubling its revenue over the past 2 years, which, I assume, is a COVID bump due to public pools being shut down. But, that is an assumption, do pool construction companies normally follow the new home construction cycle? How about pool service companies, do they see a dip if the economy takes a downturn?

Reply by a searcher
from Harvard University in Boston, MA, USA

All LBO candidates are cyclical if you look hard enough. Even a stable performing asset class will experience cyclicality around price based on the credit cycle. Read Howard Marks to really get your thinking pushed on this.

You can evaluate the company itself based on historical performance, this is OK, but alone may not tell you anything. For example, if revenue declined dramatically after 5 years of steady increases, they could have simply gotten bit by high customer concentration. Look to see whether the whole industry was suffering when their revenue declined - that will help you isolate whether it was the company or the industry. Either could still be a good investment at the right price.

Reply by a searcher
from The University of Chicago in Chicago, IL, USA

In order to determine cyclicality, you need to observe business results on a much longer timeline. Depending on the industry, a cycle can last from a few years to up to a decade. A good tell is to look at the stability of margins (gross margins, operating margins). If you see these change dramatically over a few years, this is likely a good tell that the company operates in a cyclical industry.

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