The economy moves in a cycle and has four stages: expansion, peak, contraction, and trough. In the expansion phase, the economy grows rapidly until it reaches the peak stage. Then it slows down in the contraction stage and hits the lowest point in the trough stage. Right after this, the economy starts recovering, and the expansion phase starts again. Just like the economy, some stocks also move in cyclical stages.
What are Cyclical Stocks?
Cyclical stocks are companies that follow the stages of the economic cycle. In the expansion phase, these businesses grow and earn profits. Their stock prices also go up as the economy grows. But as the economic growth slows down, these businesses phase a slump in their revenue and profits. As a result, their share prices also go down.
Companies manufacturing and selling discretionary goods and services usually fall under this category. For example, luxury clothes and accessories companies, restaurants, furniture, airline, hotel chains, and automobile companies all fall under discretionary goods and services. Consumers usually spend on these items when they earn enough to cover their basic expenses. But during tough times, consumers cut their expenses by reducing the consumption of discretionary goods and services. As a result, the revenue of such companies comes down, and in turn, the stock price comes down, further moving these companies into the contraction phase.
Some cyclical sectors are automotive, real estate, hospitality, airlines, and luxury goods.
Features of Cyclical Stocks
Stock prices follow a trend
The prices of cyclical stocks follow the economic trend. When the economy expands, stock prices also go up. In contrast, when the economy contracts, the prices of such stocks also go down. This is mainly because, in a growth phase, the company’s revenues will go up, and so will the profits, resulting in an increase in share price. With the increase in share price, the cash flows to the company will increase, resulting in higher operations leading to higher revenues. But when the economic growth slows down, the revenues and profits of the company will also face a slump, leading to a fall in share price.
These stocks have a high beta and hence are more volatile. The beta for such stocks is higher than one. A beta of 1.25 indicates a market growth of 10% will result in a 12.5% increase in the share price. But a high beta also has a downside. A 10% fall in the market will lead to a 12.5% decline in the share price of this stock.
Since the company’s revenue depends on the economic condition, the earnings also move in the same trend. In a recessionary condition, the revenue falls as consumers will be less willing to spend on discretionary goods. As a result, the earnings also fall. It is also very difficult to predict such companies’ earnings per share (EPS) as they keep fluctuating.
Low price to earnings
Cyclical stocks have a very low price-to-earnings ratio (PE) compared to non-cyclical stocks. These stocks become less desirable when the economy is falling. Hence investors avoid such stocks for the long term, resulting in lower PE.
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When Should You Invest in Cyclical Stocks?
Investing in cyclical stocks is similar to riding the Ferris wheel. Once you are on top and the next minute, you are down. Even in cyclical stocks, you earn a high profit, and then you make losses. But here, the timeline is slightly longer than a Ferris wheel, as each business cycle can last for years. Hence, timing the market before investing in such stocks is very important.
The stock market doesn’t move in tandem with the economic cycle. Instead, it moves ahead of the economic cycle in anticipation of the next phase of the economic cycle.
Ideally, you should invest in cyclical stocks at the start of the expansion phase and redeem your investment before there is a slowdown in growth. This way, your returns will be maximized with minimum losses.
Though it is difficult to identify the economic cycle before it starts, you can look out for a few things to identify the upcoming economic cycle.
- If a government policy pushes its capital expenditure upwards, it’s the start of an investment cycle.
- Next is capex undertaken by major companies. If you see all major companies undertaking a heavy capex, they are preparing themselves for an expansionary phase. In contrast, if the capacity utilization levels are low at 70-80%, the companies won’t invest in capex as they have enough to cater to any major demand. Thus, the company may not be in the expansion phase.
These are not the only indicators for identifying the exact economic cycle. Several indicators, such as falling interest rates, growth in the price of metals, or major government spending in other countries, also hint at which stage the economy is in.
Factors to Consider Before Investing in Cyclical Stocks
- Company’s fundamentals: Before investing in any company, it is important to check its fundamentals. In other words, check its revenue growth, profit growth, debt levels, cash flow position, and return ratios. A cyclical company lacking fundamentals will fail to perform well even in an expansion phase. Hence check for all these factors before investing in cyclical stocks.
- PE ratio: Check the company’s price-to-earnings multiple before investing. Usually, investors run behind low PE multiples, but in the case of cyclical stocks, a low PE may sometimes mean a risky bet. Hence, compare a company’s PE with its peers and the industry to see how it is priced. However, PE should be one of the last things you should consider while assessing a company.
- Interest rates: Cyclical stocks perform well when the economy is expanding. But that happens when the interest rates are low or falling. Hence check for the interest rate regime in the country before investing in cyclical stocks. Ideally, invest in them when the interest rates are about to fall or are falling.
- Economic changes: Cyclical stocks are very sensitive to economic changes. Any change in interest rates or government policies can affect the company adversely. Hence keep track of economic changes that might affect the company.
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Who Should Invest in Cyclical Stocks?
Cyclical stocks are all about timing. If you can get the timing right, then you can make good money by investing in cyclical stocks. Also, these stocks require you to dedicate your time to them. If you are one such investor who can spend enough time researching and keeping track of all the market changes, then these stocks will best suit you.
However, these stocks are risky bets. It requires its investors to have a very high tolerance to risk as they have a very high beta and are pretty volatile. In times of recession, these stocks can be hit pretty hard. Moreover, as an investor of cyclical stocks, one needs to be very quick and responsive to market changes to make quick decisions.
Advantages and Disadvantages of Cyclical Stocks
Advantages of investing in cyclical stocks
- High returns: Investing in cyclical stocks can be very fruitful. Perfect timing can reward you generously. Given that you’ve invested in these stocks at the right time, you can make very high returns quickly.
- Easy to identify: Cyclical stocks can be easily identified. They are companies that manufacture luxury goods, that is, goods that are not basic necessities. Any company that is offering a good or service that is not required for everyday living is a cyclical stock.
Disadvantages of investing in cyclical stocks
- High risk: It all boils down to market timing for cyclical stocks. Perfect market timing can give good returns, but getting the market timing wrong can be very risky. You can be at risk of losing your entire money. Moreover, during the recession phase, these stocks are hit the hardest. Hence it is always better to proceed with caution with these stocks.
- Uncertainty of profits: There is always a risk of uncertainty with the stock market. Even during an expansionary phase, there is no guarantee that the stock you’ve invested in will perform well. There can be many reasons for this, such as poor management, outdated technology, or high costs, all can lead to lower profits for the company. This will ultimately affect its performance on the stock market.
Difference Between Cyclical and Non-Cyclical Stocks
Following are the differences between cyclical stocks and non-cyclical stocks.
|Point of difference||Cyclical stocks||Non-Cyclical stocks|
|Product offering||Consumer discretionary products and services. Example: phones, laptops, air travel, hotel expenditure||Necessities. For example, water, electricity, and staples such as rice, salt, and wheat.|
|Industries||Hospitality, electronics, automobiles||Power, pharmaceuticals, utilities|
|Return||High return during economic growth||Stable return in all stages of economic growth|
|Risk||High risk as they are affected during the recession.||Low risk when compared to cyclical stocks.|
|Market Timing||Timing the market is everything when investing in cyclical stocks.||There is no need to time the market when investing in non-cyclical stocks.|
|Beta||Has high beta than the market.||Has low beta than the market.|
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