Cyclical stocks, which are sensitive to economic cycles, and non-cyclical stocks, which are shares of companies whose business activity does not much depend on the state of the economy, comprise most retail portfolios.
Economies mostly go through four stages: expansion, peak, contraction, and trough. A given economy fluctuates within periods of economic expansion and contraction.
It is important for market participants to appreciate the difference between these two types of stocks, whereby expected returns may vary over the economic cycle.
What are Cyclical Stocks?
Cyclical stocks are equities of companies whose underlying businesses ebb and flow with economic cycles of expansion and recession. Such cyclical businesses typically outperform during times of economic upturn and prosperity. Conversely, they generally see significant declines in revenues and profits during economic downturns.
Business activity in cyclical industries reflects the strength of the overall economy. When market conditions are unfavourable, consumers postpone or cut their spending for products or services in cyclical sectors. As a result, share prices of cyclical stocks typically reflect the level of business activity.
Indicators of Cyclical Stocks
In addition to the general industry classification, several other indicators help investors identify individual cyclical stocks.
– Beta: One of the most common is the beta value of a stock, which measures its volatility of returns relative to the entire market.
A higher beta value implies higher volatility of the share price. Cyclical stocks typically have high beta values, often more than 1. For instance, if the beta value is 1.6, the stock is 60% more volatile than the broader market.
– EPS: Another indicator is the earnings per share (EPS), calculated as a company’s net income divided by the total number of its outstanding shares. The resulting number serves as an indicator of a company’s profitability. Cyclical stocks tend to have a volatile EPS, as they heavily rely on business cycles.
– Price to earnings (P/E) ratio: In addition, the P/E ratio is usually lower for cyclical stocks due to the fluctuations in both their stock price and EPS. Note that when investors look for companies with low P/E multiples, they should also pay attention to the industry. Earnings of cyclical stocks tend to fluctuate considerably to make P/E a meaningful measure by itself. Therefore, investors need to research a given equity in depth.
Examples of Cyclical Stocks
Cyclical stocks are mostly companies that sell discretionary items that consumers and businesses can afford to buy without hesitation during an economic boom. When the economy is strong, consumers can spend their income without fear for the future as they feel their jobs are secure. But, on the other hand, they will hesitate to spend money on all non-essentials when the economy is struggling.
Understandably, there could be overlaps between sectors. For instance, a luxury name could also be classified as an automaker or a retailer. Examples of cyclical stocks from cyclical industries include:
Automobile and related businesses: According to the US Federal Trade Commission (FTC), “a new car is second only to a home as the most expensive purchase” for most Americans, and this will be similar in the U.K. Yet, the very same consumers can immediately put off such financial decisions amid economic uncertainties.
Banking: Most bank stocks are cyclical. Their profitability often drops during a recession when the demand for banking instruments declines, and many consumers struggle to pay off their debts.
Lloyds Banking Group (LLOY) and Wells Fargo (NYSE:WFC), as well as smaller banks, such as Virgin Money UK (VMUK) or TBC Bank Group (TBCG), are examples of cyclical bank stocks that are relatively recession-prone but poised to perform well during prosperous times.
Chip (or Semiconductor): These companies design and manufacture chips with a relatively short lifespan.
Commercial real estate: Similar to the overall economy, commercial real estate is cyclical.
Construction: The construction sector, which heavily relies on home buying and renovation trends, is directly impacted by economic cycles.
Luxury goods: Luxury goods makers typically have well-known brands and enjoy high operating margins. Yet, when an economy contracts and enters a recessionary cycle, discretionary spending on luxury items typically suffers from a slowdown in spending.
Media and entertainment: Digitalization has helped broaden the scope of this sector as it now includes social media, streaming, eSports and iGaming stocks as well.
Mining: A few cyclical stocks are inversely-correlated with the course of the economy. Considered a safe-haven investment, the price of gold and other precious metals tends to rise amid economic recessions.
Retail: This segment includes brick-and-mortar stores as well as eCommerce names. Economic cycles, such as recessions, can bring significant shifts in consumer behaviour, affecting how businesses adapt. For instance, when the economy contracts, off-price or discount stores are likely to do better.
Travel and leisure (such as airlines, hotels, or restaurants): During times of prosperity, travel stocks generate higher revenues since consumers can spare extra budget on non-essentials like travel. Conversely, people are less willing to spend money on travel in times of financial hardship.
Textile and apparel: Returns of shares of clothing and textile companies are also dependent on the strength of the economy.
What are Non-Cyclical Stocks?
Non-cyclical stocks are equities of companies whose underlying businesses are not disrupted by economic cycles. These companies offer products and services that meet consumers’ basic needs like food, power, water, and gas.
As a result, economic cycles have little to no bearing on the price movement of these stocks. Such non-cyclical stocks are also regarded as defensive stocks because they can help defend portfolios against an economic downturn.
Examples of Non-Cyclical Stocks
Defensive stocks are in sectors like utilities, food, health care, and consumer staples. Many have historically generated solid returns and dividends. Examples include:
– Food & Beverages: Companies providing daily essentials like food and beverages make reliable defensive stocks.
– Health Care: People do not refrain from paying for health care products, especially when they’re sick.
– Residential REITs: Individuals always need shelter, and housing is a basic need. Therefore residential REITs could be considered non-cyclical stocks.
– Utilities: This segment makes a great example for non-cyclical stocks. Even during the recession, consumers (for the most part) pay their bills for power and water.
Cyclical vs. Non-Cyclical Stocks
Knowing the differences and distinctions between cyclical and non-cyclical stocks is key to creating a balanced portfolio.
• Strong performers during periods of economic growth
• Associated with goods or services consumers tend to spend more money on during expansionary periods
• Highly sensitive to shifting economic cycles
• Earnings fluctuate during the economic cycle
• More volatile in terms of stock returns
• Typically lose value when the economy contracts, but fare better in times of economic expansion
• Many cyclical stocks are not dividend payers
• Better performers during periods of economic contraction
• Associated with goods or services that consumers consider essential
• Less sensitive to changing economic environments
• Earnings are relatively stable
• Are less volatile in terms of stock returns
• Typically hold up well during periods of economic contraction
• Most non-cyclical stocks pay dividends
Given these differences, having a mix of cyclical and non-cyclical stocks in a long-term portfolio can be an appropriate hedging strategy. Owning cyclical stocks during expansionary periods can lead to massive returns. Yet, amid economic downtrends, investors holding non-cyclical stocks can pursue more of a buy-and-forget strategy thanks to their defensive nature.