“The oil price is falling, should I sell my BP stocks.” This was a question I received via email from a reader of the site. The reader further went to ask “ Where do you think the oil price is headed? I fear that it is going lower and I should sell my BP shares.”
My simple answer to this is simple, I don’t care what is happening to the oil price at the moment – even though the price of crude has dropped by about 20%. It might shock you to learn that I am not an avid follower of the oil market even though close to 15% of my portfolio earns its revenue from crude oil. This is cause I learnt a secret a few years ago.
The greatest benefit we have today is information is freely and readily available. We have more information than any generation before us. History has been documented through countless books. We are blessed with the ability to learn from the greatest investors – living and dead – from the comfort of our own living rooms. I have taken advantage of this and have read multiple journals, hundreds of books and countless articles. And from this I learn one very very important lesson. A lesson that has been documented time and time again from some of the greatest financial wizards that ever lived. It is this – Only Buy Cyclical Stocks At Cyclical Bottoms.
Before I go any further, let me explain what cyclicals are. Cyclicals are industries whose profits and stock prices rise and fall with the economic cycle. Automobile manufacturers, oil companies, house builders and steel or aluminium producers are classic examples.
With Cyclicals, the price you pay is everything. If you pay too high a price, you risk losing a huge part of your capital. If you pay a low price, you stand in good steed to make a truck load of money.
The reason for this is because cyclicals move in constant boom and bust cycles. The worst time to buy is at the top. Many people know this in theory but it is very hard to apply in practice. This is because at the top of the market, unlike other sectors, cyclical stocks often appear cheap. They have low P/E ratios as they are making huge swarms of money at the top. But unlike a consumer staple company for instance, cyclical stocks don’t make record profits year after year. Their profits are lumpy and hugely dependent on the economy. So if you buy after record profits when the stock looks cheap due to the E (earnings) in the P/E ratio being inflated, you will be in for a nasty shock.
This is why Peter Lynch said the worst time to buy a cyclical stock was when the past financial performance was at its best. In another words, when the trailing PE ratio of a cyclical stock is low, it usually means the stock is nearing the end of the cycle.
On the other hand, when the P/E ratio of a cycle stock appears high, it is often the time to buy. This is because the E (earnings) in the P/E ratio is depressed due to the industry being at the low point of its economic cycle. You want to be buying when industry profits are low so you can ride the economic wave upwards.
This is exactly what I did during the 2015/2016 oil price crash. During that period, oil was flirting in the $30 a barrel range. This was the low point in the cycle of oil stocks. Due to the low oil price, many companies were reporting very little or even negative profit. This caused the P/E ratio of these companies to skyrocket as the E (earnings) in the P/E ratio was depressed due to the industry being at the low point int he cycle. If you thought the oil industry had a future, this was exactly the time to buy.
I went all in with money I had available at the time and bought BP and Royal Dutch Shell at historic lows. At that point, both stocks had close to 10% dividend yields. Most people who didn’t thoroughly study the accounts and business were afraid of buying the shares as these companies had extremely high P/E ratios at the time due to the depressed earnings.
What has played out since is self evidence. I have made a killing with both investments being up over 100% in less than 3 years. In addition, I still receive a huge dividend from both companies.
So that brings us to today. Because I know my purchase price was so good, I do not care what the oil price is doing from day to day. Even if both stocks were to enter a bear market and drop by 20%+, I wouldn’t bat an eye lid for as long as I believe oil has a good future ahead (LINK). By buying at a cycle low, I have ensured that my oil investments remain profitable for a very long time.