Cyclical stocks are those shares which get affected by the macroeconomic or systematic changes in the overall economy. Such shares tend to perform well during times of economic growth and tend to underperform during an economic slowdown or recession. Most cyclical stocks are of companies that enjoy high demand for their products during a booming economy which increases their share prices and during a downturn of the economy there is reduced demand for such items, consequently decreasing the share prices.
What are Cyclical Stocks
Shares of companies with consumer utility items such as television, refrigerator, air conditioning, car manufacturers, airlines, furniture retailers, clothing stores, hotels, and restaurants come under the category of cyclical stocks. During times of economic expansion, such companies experience high growth and profitability due to increase in demand of their products and the share prices rise. However, in times of economic downturn, cyclical stock companies are hit the hardest as the demand of their product reduces affecting profitability. During a downturn, the demand for utility items falls first leading to fall in revenue and corresponding profit which results in share prices of most cyclical stocks to plummet.
Examples of Cyclical Sectors
Cyclical stocks are characterized by durables, nondurables, and services. Companies producing durable goods are those involved in the manufacture or distribution of physical goods with an expected life of more than three years. Companies such as Maruti, appliance manufacturers like Godrej and clothing makers such Raymond belong to this sector. The extent of orders of durable goods is good indicator of the economic performance. A large measure of the orders is an indicator of stronger economic activity in the ensuing months.
Nondurable goods companies produce or distribute soft goods that have an expected life span of less than three years. Examples of companies that operate in this sector are Coca-Cola, Nestle and Unilever etc.
Services sector cyclical stocks are of those companies that provide services to facilitate travel, entertainment, and other leisure activities for consumers including those that operate in the digital area of streaming media, such as Amazon prime.
Key Characteristics of Cyclical Stocks.
Cyclical Stocks are characterized by share prices that fluctuate along with the prevailing macroeconomic conditions. These stocks typically rise during periods of economic expansion and decline during recessions. Following are the key characteristics: –
- Sensitive to Economic Conditions. These stocks fluctuate as per the economic conditions. The reason behind this fluctuation is that the products or services these companies offer are often considered non-essential or luxury items and people are more likely to buy them when they have extra disposable income.
- High Volatility and Fluctuations. Cyclical stocks are highly sensitive to economic cycles, making them more volatile than non-cyclical stocks. Economic downturns can result in significant declines in value and potential losses for investors.
- High Beta (>1.0). Beta (β) measures the sensitivity of a particular stock to systematic risk, i.e. the risk which is inherent to the entire market. Beta compares the volatility of a security relative to the broader market, a high beta coincides with more cyclical securities. High Beta (>1.0) ➝ More Cyclicality.
- High Risk High Return. A high-risk investment has a potential for high returns but involves the risk of loss of investment and dilution. It’s important to acknowledge that investing in cyclical stocks comes with a higher level of risk and volatility compared to defensive stocks.
Why Investors choose Cyclic Stocks.
Investing in cyclical stocks can offer significant benefits, but it’s essential to understand why and when to make the right choice. Here are few reasons to consider while investing in them:
1. Potential for high returns. Cyclical stocks tend to outperform during periods of economic expansion. As the economy grows, consumer spending increases, driving up the revenues and profits of companies in cyclical industries. There is potential for significant gains as the stock prices of these companies also increase.
2. Diversification benefits. Cyclical stocks are different from non-cyclical (defensive) stocks, which tend to remain more stable. By diversifying your investments in cyclical stocks, you can reduce the overall risk and smooth out returns across different market conditions.
3. Opportunities during economic recoveries. Cyclical stocks are attractive at the start of an economic recovery and Investors who buy during these periods can benefit from the market’s early gains, potentially reaping significant benefits as the recovery continues.
4. Sector-specific advantages. Different cyclical sectors may outperform at various stages of the economic cycle. For example:
- Consumer cyclical stocks may benefit early in a recovery as consumer confidence returns.
- Industrial cyclical stocks might gain momentum later in the cycle when infrastructure spending increases.
- Technology cyclical stocks could see a boost as businesses ramp up investment in new technologies during growth phases.
5. Long-term growth potential. Investors who are patient and can absorb short-term fluctuations may find cyclical stocks to be a rewarding component of their portfolio. While they may experience volatility, the overall upward trend of the economy over time means that well-chosen cyclical stocks can have significant long-term growth.
Risk of Investing in Cyclical stocks.
While investing in the best cyclical stocks can lead to extensive profits, certain disadvantages of such shares should be kept in mind to ensure maximum profitability: –
- High Risk. The price of a cyclical equity share is associated with severe fluctuations, corresponding to business cycle changes. In the event of the downturn of the production cycle, the share prices fall drastically, implying severe losses for individuals. They can suffer mammoth losses during severe recessions and can have a hard time surviving until the next boom.
- Uncertain profits. Consumer utility goods are heavily dependent on the tastes and preferences of citizens. With evolving technology leading to the launch of new gadgets every day, companies engaged in the production of such items often lose their competitive edge if they fail to keep up with the latest trends and customer preferences. This might lead to significant losses even during times of economic boom owing to reduced demand for outdated products.
How to invest in Cyclical Stocks.
As with any investment, it’s essential to conduct thorough research and consider individual financial goals and risk tolerance before investing in cyclical stocks. With the right approach, cyclical stocks can be a valuable addition to a well-rounded investment portfolio.
Understand Market Dynamics.
To invest in Cyclical stocks an investor must build a comprehensive understanding of the market dynamics and risk management techniques. Since the cyclical stocks performance is dependent on business cycle fluctuations, the pattern of such variations must be recorded to ensure investment is made at the right time. Investment should be made during the recessionary phase of the economy which often leads to extensive capital gains during its revival. Individuals with an investment goal of capital gains should look out for adverse business cycle fluctuations and analyze the business cycle trends to maximize gains.
Contrarian Investing
Taking contrarian position that goes against prevailing market trends and sentiment is known as Contrarian Investing. Contrarian investors would seek opportunities to buy undervalued stocks in sectors experiencing temporary downturns and hold for an upturn / revival. This strategy requires patience and a contrarian mindset to capitalize on potential market reversals.
Sector Rotation
Sector rotation involves reallocating investments across different industry sectors based on their performance relative to the economic cycle. Investors employing sector rotation strategies may increase exposure to cyclical sectors during economic expansions and shift towards defensive sectors during downturns. By actively managing sector allocations, investors can optimize returns and reduce portfolio risk.
Long-Term Value Investing
Long-term value investing focuses on identifying fundamentally strong companies within cyclical sectors and holding investments for an extended period. By conducting thorough fundamental analysis and assessing the long-term growth prospects of companies, value investors can build a diversified portfolio of cyclical stocks with the potential for sustainable returns over time.
Conclusion
Cyclical stocks offer investors the opportunity to leverage economic cycles for potential gains but require careful consideration of timing, risk management, and diversification. By understanding the characteristics of cyclical stocks and employing strategic investment practices, investors can navigate the volatility and capitalize on the opportunities these stocks present.
