Perhaps the most basic principle underlying the field of economics is that of supply and demand. When the two are in balance, price finds a relatively steady equilibrium. When demand outstrips supply, prices rise until the market can balance through either an increase in supply or a reduction in demand. Conversely, as supply outpaces demand, prices fall until demand moves suitably higher or supply comes out of the market.

Simple as it may seem, the principle forms the foundation of our Hurdle Rate investment strategy.

The Hurdle Rate strategy applies to deeply cyclical industries that tend to sell commoditized products. Materials and energy markets are recognizable examples, but you can also think about the airlines industry or memory semiconductors as others. These industries are highly cyclical in nature, and often trend toward extremes until we get sharp reversals, which can be both rapid and painful.

In deploying this strategy, we look for parts of the market where supply and demand have moved out of equilibrium, such that supply has outstripped a sustainable level of demand. Over time, this situation must correct. Returns and profitability will ultimately suffer, and there may be significant pain in the industry (potentially manifesting itself in capacity closures or bankruptcies).

It’s at this point that we may want to be invested in what we consider to the be the “cement mixers” – the companies that have a degree of durable competitive advantage that will enable them to weather a storm. Characteristics may be a particularly strong balance sheet, low-cost production, access to capital, or a combination of these (or others). As capacity leaves and demand starts to pick back up, prices rise, and earnings improve. All the while, we’re closely observing to exit the position at the right time, ahead of the cycle playing out again, monitoring points focus on high-cost production coming online to chase prices higher, sowing the seeds of the next leg down.

The Hurdle Rate Strategy in Action

We recently identified such a setup in the lumber industry with West Fraser. The company is one of the largest lumber producers in the world and is a low-cost producer with industry-leading margins through-cycle. Its investment grade rating is reflective of the strength of both its balance sheet and the quality of its operations.

The industry itself is seeing significant pain. The North American lumber industry is heavily exposed to residential construction, representing nearly 75% of demand, and the hiking cycle we have seen play out has weighed heavily on activity. Lumber prices have fallen at a time when costs have risen, with margins and returns turning negative in many instances and capacity utilization well off its highs. This, in turn, has led to layoffs and permanent capacity closures. The setup we have monitored allowed us to implement our strategy at a time when valuations are compelling, too.

As with any investment, our process identifies clear monitoring points that enable us to track our investment thesis over time. Here, though, we will be laser-focused on not only West Fraser, but industry-level developments to ensure that the Hurdle Rate is tracking as expected. Given the nature of the strategy, a peak in prices and increasing risks as the cycle grows longer in the tooth are the key monitoring points we’re watching for to actively manage the opportunity and see the strategy play out.

Overall, the conditions needed to deploy the Hurdle Rate strategy are fairly specific and play out over longer periods of time. As a result, we may go through periods where we see little to no representation of the strategy in our portfolios. Yet when the conditions do present themselves, you can expect us to move aggressively and decisively to take advantage of industry-level conditions to deploy our time-tested strategy and gain exposure to attractive opportunities in deeply cyclical industries.

This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.