Investing in cyclical stocks

What are cyclical stocks?

Cyclical stocks are stocks of companies whose prices move strongly with the state of the economy. These are usually companies that provide non-essential goods and services. If the economy grows, cyclical stocks typically benefit. If the economy goes into recession, cyclical stocks often fall sharply.

The performance of cyclical stocks is closely tied to the overall health of the economy. When the economy is strong, cyclical stocks tend to do well because consumers have more money to spend. However, during recessions or economic contractions, cyclical stocks can suffer as people cut back on spending.

To build a diversified portfolio, it's important to include both cyclical and non-cyclical stocks. This helps cushion the impact of economic downturns on your investments.

Not all cyclical stocks are the same. Some companies within cyclical industries may be more resilient than others. Before investing in any individual stock, it's crucial to conduct thorough research and analysis.

You can take a long-term perspective when investing in cyclical stocks. If you believe in the industry or company's long-term growth potential, you may choose to hold onto the stocks even during economic downturns. This requires patience and the ability to withstand short-term fluctuations.

Why do cyclical stocks move with the economy?

Cyclical companies usually sell services and products that can be considered non-essential. These can be luxury products like smartphones and cars, travel industry services or commodities that are in greater demand due to increased production when the economy is doing well.

Examples of non-cyclical stocks include Ahold Delhaize and Unilever. These companies are both in the food sector. Whether the economy is doing well or not, people will always need food. This makes the sales of these companies less sensitive to economic fluctuations.

What stages can we distinguish during an economic cycle?

The economy often moves in a cycle that begins with a period of economic growth and then goes into recession. Then comes a period of recovery, after which the cycle begins again. These are the four stages of the economic cycle:

• Expansion
• Stagnation
• Recession
• Recovery

The cycle begins with a period of economic progress. The economy is running at full throttle and there is high demand for non-essential products and services. At some point, the economy flattens out and growth reaches its peak. The economy stagnates. After this period of stagnation, a contraction of the economy takes place. Demand for non-essential products and services declines sharply. A recession is followed by a period of recovery. After this period, the cycle begins again.

There is no set recipe for the course of an economic cycle. For example, a period of stagnation is not necessarily followed by a recession. There can also be another period of economic growth that eventually turns into a recession later on.

Examples of cyclical industries

Cyclical stocks can be found in the following industries:

• Aviation and travel industries: People usually go on holiday, catch a flight, take a city trip or book a hotel when the economy is doing well. In times of economic downturn, we holiday less often and spend less money on leisure.

• Automobile industry: Cars are luxury products and buying a new car is a substantial investment for most people. These products are less likely to be purchased when the economy slows down.

• Raw materials and chemicals industry: When the economy is on a downturn, fewer raw materials are needed. This is because the demand for products is lower and therefore fewer products are produced that require these raw materials.

• Real estate and construction sector: Homes and commercial properties are built, sold and rented more frequently when the economy is booming. If a country's financial situation deteriorates, this is often directly reflected in the construction, renting and sales of real estate.

• Financial sector: When there is less money in circulation and fewer loans being taken out, banks and other financial institutions earn less. In turn, the state of the economy affects the financial sector.

• Technology sector: Luxury products such as TVs, laptops and other electronics are sold less when people have fewer to spend during a recession. Consequently, many chip manufacturers see their sales decline as their chips are incorporated into these devices.

Early- and late-cyclical stocks

With cyclical stocks, we can distinguish between early-cyclical and late-cyclical stocks. An early-cyclical stock reacts almost immediately to a fluctuation in the economic environment. A late-cyclical share reacts later.

Shares of companies that offer or produce luxury products and services such as electronics, holidays, trips and cars are classified as early-cyclical shares. You see a decrease or increase in these almost immediately when the economic climate turns.

When the economy is doing well, the construction sector usually flourishes later. Shares of companies in the construction sector can therefore be called late-cyclical shares. Construction plans often have a long run-up as they take a while to get going.

Getting in and out at the right time

Timing is important when buying cyclical stocks, because they are very volatile. Getting in at the wrong time can mean buying stocks that are at their highest point in the cycle in terms of price. On the other hand, you can pick up stocks at a bargain price at the low point of a cycle.

When timing entry and exit points, it is important to learn about the industry of the stocks you are buying. The better you know the product or service of the company whose shares you want to buy, the better you can estimate the right buying or selling moment of a cyclical stock.

Examples of cyclical stocks

Cyclical stocks can be found in sectors like consumer discretionary, industrials, materials and technology. These sectors include companies in industries such as retail, travel, manufacturing, construction and mining. Here are five examples of cyclical stocks:

• Volkswagen AG (VOW3): Volkswagen is a German automobile manufacturer and is highly influenced by economic cycles. During economic expansions, car sales tend to increase, benefiting Volkswagen. However, during economic downturns, car sales usually decline, affecting the company's financial performance.
• Hennes & Mauritz AB (HM-B.ST): H&M is a Swedish multinational clothing retail company. It operates in the consumer discretionary sector and is highly sensitive to economic conditions. During economic expansions, consumer spending on fashion and clothing tends to increase, benefiting H&M. However, during economic downturns, discretionary spending on clothing may decrease, impacting how the company performs.
• Boeing Company (BA): As a leading aerospace manufacturer, Boeing's performance is highly cyclical. Demand for new aircraft is closely linked to economic conditions. During economic growth, airlines expand their fleets, increasing demand for new aircraft. Conversely, during economic downturns or industry challenges, such as the COVID-19 pandemic, demand for new aircraft declines.
• The Walt Disney Company (DIS): Disney is a cyclical stock due to its reliance on consumer spending and discretionary income. The company generates revenue from theme parks, media networks and entertainment properties. During economic expansions, people spend more on holidays and entertainment, benefitting Disney. However, during economic downturns, consumer discretionary spending may decrease, impacting the company's financials.
• United Airlines Holdings, Inc (UAL): Airlines are classic examples of cyclical stocks. Their performance is closely tied to consumer travel demand, which fluctuates with the overall economy. During economic growth, people travel more for business and leisure, leading to increased airline ticket sales and profitability. However, during economic downturns, travel demand can significantly decline, impacting airlines' results.

Investing in cyclical stocks

Investing in cyclical stocks requires careful analysis, understanding the business cycle and considering various factors that can impact their performance. Here are some steps to help you invest in cyclical stocks:

• Research & identify cyclical sectors: Start by identifying sectors that are considered cyclical, such as consumer discretionary, industrials, materials and technology.
• Analyse economic conditions: Stay updated on the overall economic conditions and the stage of the business cycle. Monitor indicators such as GDP growth, employment rates, consumer spending and interest rates to gauge the health of the economy.
• Select specific companies: Once you have identified cyclical sectors, research individual companies within those sectors. Look for companies with strong fundamentals, solid management, competitive advantages and a history of navigating economic cycles successfully.
• Analyse financial statements: Evaluate the financial health and performance of the companies you've selected. Examine key financial metrics like revenue growth, profitability, debt levels and cash flow. Consider how these metrics have varied during different stages of the business cycle.
• Understand industry dynamics: Gain insights into the specific industry dynamics that impact the companies you have picked. Consider factors such as supply and demand dynamics, regulatory environment, competitive landscape and technological advancements. Assess how these factors could influence the company's performance during different economic conditions.
• Diversify your portfolio: To mitigate risks associated with cyclical stocks, diversify your portfolio across different sectors and asset classes. This will help offset potential losses from underperforming cyclical stocks with the stability of non-cyclical stocks or defensive assets.
• Monitor and adjust: Keep a close eye on economic indicators, industry trends and company-specific developments. Regularly review your investment thesis and adjust your portfolio as needed to capitalise on changing market conditions.

Pros & cons of investing in cyclical stocks

Pros of investing in cyclical stocks

• Growth potential: Cyclical stocks can experience significant growth during economic expansions as consumer demand for non-essential goods and services increases.
• Low valuations: Economic downturns may cause cyclical stocks to decline in price, creating opportunities for investors to buy at discounted prices and potentially earn higher returns when the economy rebounds.
• Dividend potential: Certain cyclical stocks, particularly in sectors like consumer staples or utilities, may offer stable dividends even during economic downturns, providing a steady income stream for investors.
• Portfolio diversification: Including cyclical stocks in a diversified portfolio can help balance risk exposure, as their performance often differs from non-cyclical stocks, reducing the impact of economic fluctuations on overall portfolio returns.

Cons of investing in cyclical stocks

• Economic sensitivity: 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.
• Timing challenges: Timing the entry and exit points of cyclical stocks can be difficult, requiring accurate predictions of economic cycles and understanding industry and company dynamics. Mistimed investments can lead to missed opportunities or losses.
• Industry-specific risks: Different cyclical sectors face unique risks. For example, industries like travel and tourism are vulnerable to external shocks, such as geopolitical events or pandemics, which can greatly impact stock prices and company performance.
• Volatility: Cyclical stocks rely on consumer discretionary spending, which can decrease during economic downturns. Slower consumer spending can lead to reduced sales and profitability for companies in cyclical sectors.
• Higher risk: Investing in cyclical stocks carries higher inherent risk compared to non-cyclical stocks. Investors need to carefully assess their risk tolerance and be prepared for potential market fluctuations and volatility.