Gamble of the week: A classic cyclical stock

This is a classic cyclical stock. The company distributes electronic components that are bought by design engineers across the world to go into pretty much any product that relies on electronic technology.

As a result, this stock’s fortunes are closely tied to the ups and downs of the world economy and the pace of innovation in new electronic products. The theory goes that as the economy picks up, more customers should be buying components from it. This in turn means more profits, bigger dividends and a rising share price.

On top of this, it should also benefit from the ongoing pressure on companies to be as lean as possible. Piling up stocks of components in warehouses burns cash – ideally companies should be ordering them in from distributors for delivery at one day’s notice.

This is the role that Premier Farnell (LSE: PFL) tries to fill, and it seems to do a pretty good job of it. It currently sells more than 500,000 products sourced from over 3,500 suppliers to customers all over the world. It is beefing up its business so that more of it takes place online, which makes it easier for customers to source.

The plan is for Premier Farnell to become a global go-to company for all customers’ component needs. If it can achieve this goal , it will take a bigger slice of the market from smaller local distributors and make more money.

However, it’s been a rocky ride for shareholders in recent years. The share price is very sensitive to changes in sentiment about the health of the global economy. Any disappointments in sales and profits have been punished hard by the market.

Premier Farnell share price chartThe trouble with this firm is that it’s hard to predict its future. There’s a good case to be made for strong growth from emerging economies as the pace of innovation increases. But what this means for Premier Farnell’s actual quantity and value of orders, and hence sales and profits, involves a lot of guesswork. In short, you’d hope that the long-term trend for profits is upwards.

Having bounced at the end of 2013, the company’s shares now seem to be stuck in a bit of a rut. Some investors are disappointed that profit margins are not increasing. The company says this is due to extra investment and that they will go up if markets are kind to them.

That leaves us with the share price of 226p, which equates to 14.7 times expected earnings. That’s not dirt cheap by any means, but if business picks up, then profits and the share price could move higher from here.

Verdict: a risky punt