Cyclical and Non-cyclical stocks: How do they differ?
The best offense is a good defense. Just like in military combat or football, investors also need a good offense and defense strategy. In other words, you need to use more than one strategy in order to succeed. As a serious investor, there are many different ways you can do this. You can invest in a variety of stocks, cash, and other securities, you can also diversify your portfolio by investing in securities across various sectors and markets or you can invest in stocks that are at different growth and value levels.
Implementing the right strategy requires a good knowledge of the global economy and how the markets work- if you don’t have a good understanding of this, making decisions become incredibly difficult. As we all know, the economy goes through different business cycles and while we can’t predict the outcome of the cycles we can alter our decisions to keep up with the ever-changing landscape. This changing environment also provides a great way for investors to mix up their portfolio, namely with investing in cyclical and non-cyclical industries.
What are cyclical stocks?
As the name suggests, cyclical stocks are those that move in the direction of the market. That is when the economy is doing well, the stocks go up and when there is a downturn in the economy, the value of the stock goes down too. These stocks are more closely aligned with the broader economy and are more prone to economic activity.
For many investors, the movement of stock in cyclical industries provides a great opportunity to earn revenue on the stock by buying when there is a downturn and selling when there is an upward trend. For a novice investor, this may seem like a fool-proof strategy but be cautious, as it is almost impossible to tell when there will be a downturn in the market.
Cyclical industries usually may include durable goods (that last for a long time into the future), non-durable goods (that have a short shelf life) and services like automobile, construction, and travel.
When the economy is doing good and the people are earning well, they may spend a lot of money on buying a new car, constructing their new house or even plan fancy off-shore travels. However, when there is a downturn in the economy, people may prefer to hold these expenses for another year or two.
Around 75 percent of the stocks listed in the stock exchange are cyclical and follow the market trends. A few examples include Ferrari NV (RACE), Alibaba Group Holding Ltd. (BABA) and Royal Caribbean Cruises Ltd. (RCL).
What are non-cyclical stocks?
While cyclical industries may seem like a good investment, every good offense needs a defense, hence, it is important to balance out your portfolio with non-cyclical or defensive stocks. During a boom, people splurge on goods and services such as travel and cars. But during a slump, people stop spending on purchases that they don’t consider a basic necessity, instead they focus their spending money on food, water, and shelter.
During an economic recession or depression, the revenue and cash-flows and share price of non-cyclical companies continue to do well because they are industries that produce the basic needs of life that people will continue to consume.
In addition to basic needs, non-cyclical stocks also include those goods that are addictive such as tobacco or alcohol which can put ethical investors in a tricky situation as these industries do well even during a slump and reduces the number of industries that they can invest in.
Defensive stocks include goods and services in industries that are not affected by market fluctuations such as utilities, food, and medicines. It is basically any good or service that people will buy whether or not the economy is doing well. A few examples of defensive stock companies include Kraft Heinz Company (KHC), Johnson and Johnson (JNJ) and Sysco Corporation (SYY).
Bonus: The top-down strategy
There are two main investing strategies in the market, the top-down approach, and the bottom-up approach. The top-down approach involves looking at the economy as a whole and picking stocks that do well during certain economic conditions. This strategy requires the investor to have a good understanding of the macroeconomy along with its various sectors and industries to know what industry will perform well during the different business cycles. They also need to assess the inflexion points in the economy, that is when a certain stock price is expected to go up or down. For cyclical and non-cyclical stocks, top-down is the most commonly used strategy.
The bottom-up approach, on the other hand, involves looking at the stock individually and making investment decisions based on independent parameters.
When using the top-down approach, there are many indicators that investors can use to study the market. The first and most obvious metric is the GDP (Gross Domestic Product). This is the total value of all the goods and services produced in the economy and gives us a good understanding of the overall economic health.
Another great indicator is the ‘Purchasing Manager’s Index (PMI). This is a survey conducted among the purchasing managers in different sectors and industries in the economy. The PMI provides the investor with information on how the businesses are currently performing and which direction the economy is headed.
A third metric is the Consumer Price Index (CPI). This will give an investor insight into the changing price levels of goods and services in the economy and is a reflection of the state of the economy.
The top-down strategy is considered successful when the cyclical and defensive stocks are in perfect correlation with each other. A 100% correlation would mean that the stocks move in synch with each other while a -100% correlation means that the stocks are still in sync but move in the opposite direction.
During the 2008 recession, luxury goods such as Ford cars faced a huge decline in the value of their stock as people stopped spending on expensive items when the economy was down but at the same time, the stock for beverages such as Coco-Cola continued to do well as people spent money on this regardless of the business cycle.
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It is important for every investor to have a balanced and diversified portfolio with both cyclical and non-cyclical stocks.
Cyclical stocks include more luxury goods and hence a provide a higher return than non-cyclical stocks. However, the investor needs to study the market carefully and have a good tolerance for risk. Defensive stocks are safer investments but provide lower returns but are better for investors looking for safe investments Remember low risk, low return.