Is it Good To Invest in Cyclical Stocks?
Akin to how the pedals of a cycle go up and down as it moves forward, the share price of certain stocks goes up and down in accordance with the economic cycles a country goes through. These stocks are aptly named as cyclical stocks and in this article, we will understand what cyclical stocks are and whether it’s good to invest in them or not.
Cyclical stocks belong to those sectors that have a direct relationship with economic growth. They follow the economy's footsteps, closely tracing the economy as it cycles through the phases of expansion, peak, recession, and recovery. These sectors typically see a multiplier effect in the demand and services during the expansion phase of the economy.
Construction, steel, cement, capital goods sectors are typical examples of cyclical industries.
The industries like automobile, luxury goods, Hospitality and travel do not directly link with economic growth but economic growth has an indirect impact on their business. The effect is usually because of the higher disposable income in the hands of people and they tend to spend it on these discretionary items. These are also called cyclical industries.
Now before we look at why and when one should invest in cyclical stocks, let’s get into the details of how the economic cycle impacts cyclical businesses.
As we discussed previously, economic expansion leads to increased demand for goods and services requiring discretionary spending. To meet the demand, these companies increased production by purchasing new equipment, buying extra machines, taking additional warehouses on a lease, and investing in other utilities required to cater to this increasing demand. This then translates to more revenue and higher profit margins for such companies which may reflected in the rise of their corresponding stock price as the demand for such goods and services increases in leaps and bounds as the economy expands.
Then, when the inevitable peak has been crossed and the economy starts slipping into a recession, the demand for such goods takes a hit. This reduction in the demand is a result of people cutting down on economic activities and discretionary spending, which consequently impacts the profit margins of companies producing these goods and as a result, their respective stock price goes down.
When the economy's recessionary phase starts to subside and the next expansionary phase is about to begin, cyclical stocks start looking cheaper. This is a good time to start investing in cyclical, as these stocks hold the potential to yield huge returns if you buy them when the economy is about to expand and sell them off right before the beginning of a recession.
You ride the wave of increasing stock prices and liquidate just before this wave crashes.
Let’s now go through the advantages of investing in cyclical stocks.
The stock prices of cyclical stocks are impacted heavily due to economic cycles. These stocks hold the potential to give you returns that outperform the market when the economy is in its expansionary phase.
And as we just discussed, when the economic cycle is at the bottom, cyclical stocks are mostly available at a very reasonable valuation. So buying such stocks at the bottom of the cycle, right before the economy starts booming and selling them off right before another economic slowdown begins, holds the potential to yield good profits.
Then, how should you go about identifying cyclical stocks?
The golden rule is to choose those industries which are poised for a revival after an economic slowdown. We also know that industries reliant on discretionary spendings, like luxury retail, airlines, automobiles and other industries are often cyclical. Within this, it is better to select industries in accordance with your risk appetite. Large-cap companies are usually the safest and small-cap companies can be particularly volatile, due to which they hold the potential to yield higher returns.
Presumably, one of the best times for cyclical stocks to witness a boost would be when the government is planning on investing large amounts of capital. Let’s understand this through an example.
In 2003, the Indian government decided to undertake the Golden Quadrilateral Project, which aimed at connecting the most industrious cities in India, Delhi, Kolkata, Mumbai and Chennai through a huge network of highways, forming the shape of a quadrilateral. It must be obvious that the resources required for this undertaking would be humongous. The subsequent demand for construction material and related services, capital goods, etc. to construct such a substantial project ended up boosting the stock price of BHEL, L&T, Tata Power, Crompton Greaves so much that they became multi-baggers during the period of 2003-2011. But after 2011, the price of these stocks subsided and they became laggards.
It is clear from this example that investors would have made solid returns if they bought such stocks at the bottom of the cycle and liquidated right before they became laggards.
Let’s now deal with the disadvantages which cyclical stocks come with.
Cyclical stocks are dependent on the economic outset of a country and due to this dependence, they also happen to be pretty volatile. It is tough to foresee the implications of any incident on the economic cycles of a country. Take the example of the Covid-19 pandemic, which severely impacted markets throughout the world.
It isn’t easy to anticipate which event can either kickstart a bull-run or result in an immediate turnaround from a bull-run into a recession. The volatility which comes with cyclical stocks holds the potential to give exponential returns in a boom and exponential losses when recession hits.
The main concern with investing in cyclical stocks is market timing, and cyclical stocks do not fit into the picture of ‘buy it and forget it’ stocks. As we now know that if you wish to clock in good profits, you have to buy at the bottom of a cycle, right when the economy is about to expand and liquidate after the peak has been crossed, right before the slump begins.
The volatility associated with cyclical stocks is a double-edged sword. You can earn handsome profits or incur debilitating losses due to this volatility. Timing your entry and exit is the key to avoiding losses and it’s difficult to get the timing right, but it is paramount to get the direction of the rally right so as to maximize your profits while minimizing losses, if any.
As it isn’t wise to put all your eggs in one basket, diversifying your portfolio to consist of both cyclical stocks and defensive stocks, which are relatively stable and not as heavily impacted due to economic cycles, is always a good idea. Sectors like FMCG, Healthcare, etc. are not dependent on the economy and considered as defensive stocks.
To conclude, let’s summarize everything we discussed:
- Cyclical stocks tend to follow the ups and downs of the economy.
- When the recessionary period of the economy starts subsiding, cyclical stocks are considered to be undervalued as the corresponding cyclical companies will witness increased demand when the economy starts booming again.
- Cyclical stocks hold the potential to give market beating returns during expansionary phases, but they can also yield debilitating losses if they are not sold once the expansionary period is over.
- That is why it is extremely important to buy cyclical stocks at the bottom of a cycle and sell them off right before the economic downturn begins.
- It is always better to diversify your portfolio by including a mix of cyclicals as well as defensive stocks.
- During phases of economic expansion, cyclical stocks' prices may increase, and in economic downturns, the price may fall.
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