Why do low P/E ratio cyclicals make bad investments?

This is a question I’ve been asking myself lately. I’ve seen many people make this comment on #FinTwit, especially when it comes to energy stocks. Since much of my portfolio is tied up in energy, I’ve been increasingly curious if I’m one of those people who are fated to lose a bunch of money.

At the moment, many energy stocks have low p/e ratios. For example, one of Warren Buffett’s favourite energy stocks Occidental Petroleum (OXY) has a p/e ratio of 7.12. That’s pretty low. If we follow the rule about investing in low p/e ratio cyclicals, we’d swipe left on Oxy without any hesitation. Yet, the world’s greatest investor has spent $12 billion investing in it over the course of 2022. Why would he do that?

To answer the question let’s examine the quote from Lynch again. 

As more investors head for the exits, the stock price will plummet. Buying a cyclical after several years of record earnings and when the P/E ratio has hit a low point is a proven method for losing half your money in a short period of time.

Peter Lynch

What’s often overlooked in the statement is the direction the p/e multiple takes. Early in the cycle earnings are growing and subsequently the price is increasing. The p/e ratio is going from low to high. Then at some point the earnings stop growing and people start selling the stock. The direction of the p/e ratio flips and goes from high to low. 

Bargain hunters like myself might be tempted to buy at this point but that would be a mistake. That’s the point Lynch is trying to make in his statement. The valuation might be cheap but the direction of the earnings and subsequently the price is downwards. 

Investing in low p/e ratio cyclicals isn’t necessarily a recipe to lose money. Investors also have to consider the direction of earnings. That’s why Warren Buffett is investing in OXY despite it’s low p/e ratio. I’m also investing in low p/e cyclicals. You can see my portfolio by subscribing.