Cyclical Stocks
Investing in cyclical stocks gives one the experience of at times being on top of the world and at other times being down in the dumps! Cyclical stocks mirror the economy, when the economy is on an upswing such stocks do well and when there is a slump in the economy the value of such stocks also tend to fall. Share prices of cyclical stocks thus follow business cycles.
Business Cycles
Business cycles are the fluctuating and recurrent levels of economic activity that an economy experiences over a period of time. A business cycle is characterized by a some what predictable, long-term pattern of alternating periods of economic resurgence and decline. Among other variables the cycle involves unemployment rates and inflation also. A rise in these factors does not bode well for the economy, whereas a decline is cheering news.
There are five stages of business cycle :
1. Growth
2. Peak
3. Recession
4. Trough
5. Recovery
Earlier business cycles were thought to be extremely regular and of predictable durations. However, in todays world business cycles are irregular and can vary in duration, magnitude and frequency.
Cyclical Stocks
Cyclical stocks are the stocks of companies that are sensitive to business cycles and whose performance is strongly linked to the overall economic scenario. Such companies generally produce something or provide some service the demand for
which is high during economic upswing and low during a downturn. Examples of such are automobile, steel, fine dining, housing, capital equipments etc.
The cyclical stocks are identifiable by the dependence of their success on the well being of the economy. A representative example is the stocks of automobile companies. Buying a car is not a necessity and often the purchase is accelerated or delayed depending on a persons financial condition, which is very much linked to the performance of the economy as a whole.
Movement in Cyclical Stock Prices
Usually, the price of cyclical stocks leads the business cycle by about six to ten months and the stock price may start declining while the economy seems to be still going strong. The stock price of a cyclical company starts rising just before an economic high starts and falls just before an economic downturn sets in. An investor in cyclical stocks tries to maximize his return by buying the stock at the bottom of a business cycle and selling it once the turnaround takes momentum.
Investing in Cyclical Stocks
The price of cyclical stocks is highly correlated to economic fluctuations. While non-cyclical stocks (also known as defensive stocks) earn a profit irrespective of the economic fluctuations since they produce or distribute goods and services that are necessities eg. Food, power, water etc. The sale of cyclical stock companies depend on whether or not the economy is doing well, sales will do well only when people have surplus money to spend on luxuries and the sales will go down as and when the economy slumps.
Considering the fact that business cycles are a continuous process it is evident that cyclical stocks will also fluctuate accordingly. Successful investment in cyclical stocks will require correct timing. It is possible to make a lot of money if you time your entry in these stocks at the bottom of a down cycle just ahead of an upturn. However, investors can lose a lot of money in these stocks if they buy at the wrong point in the cycle. So, these are high risk, high gain investments.
Cyclical stocks are an embodiment of the buy low and sell high philosophy. Astronomical gains are possible if one invests at the bottom of the down cycle, just before the upturn. However, this will look contrary to popular opinion at that point in time and will need conviction and courage, as popular opinion will be against these stocks as their business will be at its lowest. The stocks should be sold while the going is still good, as the stock prices change first and the economy registers a change with a time lag.
Investing in cyclical stocks is for investors who are willing to do some research and who are ready to keep churning their portfolio as and when circumstances demand. It is not the type of stock where one can put in money and then forget all about it. One should be ready to buy and sell as one foresees a change in the business cycle coming up. It is not a form of investment for risk averse investors.
Selecting Cyclical Stocks
Before selecting a cyclical stock, one should choose an industry that is up for a bounc e. In this industry choose companies that are the best. The bigger companies are the safer ones. Cyclical stocks are not the buy and hold type of long term investments. If the economy shows signs of recession investors should readily off load cyclical stocks. If they are stuck with such stocks at times of recession then they may have to wait even five to ten years to get back the value of their initial investments.
Valuing Cyclical Stocks
The traditional manner of looking at Price-to-Earnings ratio is not indicative in case of cyclical stocks. The excessively volatile nature of their earnings makes this measure misleading. Earnings of such stocks often move up or down in excess of the movement in their stock prices, this leads to a paradoxical situation of low P/Es for these stocks at that point when they have the highest prices.
Thus, P/E ratio is not pertinent while valuing cyclical stocks. As laid down by Ben Graham, the father of value investing, an investor should pay for a cyclical stock based on the average earnings of the company over a period of ten years. This time frame of ten years is supposed to consider an entire business cycle and hence even out the highs and lows.
Conclusion
It should be clearly understood that while cyclical stocks provide an opportunity to make windfall gains, the possibility of losing a lot is also very true. Investment in such stocks is only for the educated investor and one who is willing to take on more risk because of the prospect of high gains.
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