Understanding Cyclical Stocks

The nature of the underlying business is that the business prospers in a thriving economy; there is a lot of cash flow into the business. Whereas, during a recession, the business struggles to generate revenue due to declining sales. The expense ratio of the goods or services of these companies is high. It does add additional expenses when the economy is in great shape. Consumers who purchase this product or service cannot avoid buying it because of the appeal of these products in their life—some of them such as finance-related products, Saas, banks, etc.

To identify the cyclical stock, one must understand the Beta measures as a stock’s volatility calculated concerning stock volatility and overall market performance. The defensive stocks usually come with a low beta because it is less affected by the market disruptions. You may wonder now what are cyclical stocks. 

Cyclical Stock Meaning: A cyclical stock is a price-sensitive to the macroeconomic changes in the economy. A cyclic stock forms cyclic patterns on its stock chart over some time. When the macroeconomic conditions are favorable and the economy is thriving, the price of these stocks shoots up. On the other hand, during recessions or uncertainties, the stock price of cyclic stocks plummets. This cycle continues to repeat with changes in the economy.

A business providing non-essential goods and services generally exhibits a cyclic nature. High employment, government incentives, and other economic growth policies can cause a cyclical stock to rally upwards. At the same time, factors like inflation, supply chain shortages, and uncertainties like wars and epidemics cause a significant fall in the price of cyclic stocks. Here, the company’s earnings are flat if there is no decline. You must have understood what are cyclical stocks in India, let’s discuss cyclical companies and industries in detail. 

Cyclical Companies and Industries

Stocks belonging to the following industries show cyclical natures and fall under the category of cyclical stocks in India. 

Automobile Industry

The automobile industry is one of the most infamous industries known for its cyclical demand. People tend to purchase cars during festive seasons or in a booming economy when the employment rates are high. During these periods, the automotive manufacturer can produce and sell more cars. 

Hence, the company’s sales also boomed, reflected in the rise of the company’s stock price. Whereas during periods like recessions, people would avoid buying cars, as purchasing automobiles does not come off as a necessity to most people. They would try to save more money during a recession and only make essential purchases.

Consumer Durable Goods

Consumer durables include air conditioners, television sets, washing machines, and fridges. People do not replace their washing machines or fridge every year. When necessary, people only replace their old fridges or washing machines and have excess cash to spend.  Like automobiles, these goods also do not fall under the essential label and exhibit cyclical demand. 

Infrastructure

When the economy is thriving, and the government has a lot of cash to spend, the government comes out with different incentives to boost infrastructure development. During such times, infrastructure and construction stocks start rallying. 

The price of steel and cement stocks also tends to rise when many infrastructure projects are set up. This is because both cement and steel are necessary for constructing buildings and factories. Whereas, during quiet times, when there is a lack of construction, infrastructure, steel, and cement stocks fall.

Advantages of a Cyclical Stock

It is very lucrative for investors to hold cyclic stocks when the economy goes through an expansion phase. An economic boom typically leads to a long bull market. In a bull market, indices like the Nifty 50 and the Sensex are likely to make new all-time highs. In this scenario, it is very common for a cyclical stock to outperform the broader market. The price of a cyclical stock continues to aggressively shoot up until the bull phase of the market has reached its peak. Investors can quickly make high returns if they have a cyclical stock that benefits from the thriving economy.  

In this phase, the underlying company’s business performs well and gives excellent financial results. As a result, the company is likely to show strong sales and earnings growth and give out good dividends to its shareholders. A cyclical stock rarely enters a phase of consolidation or correction in a bull market until the cycle of economic prosperity comes to an end.

The cyclical stock companies are widely spread on the stock exchange. One can easily spot cyclic stocks. Luxury and expensive goods categorize the companies that work to produce goods and services. These are not necessary for survival but still, have a high customer band in the market. An investor can group these stocks and find the right time to invest and grow in the Stock Market.

You can easily spot the business cycle fluctuations by keeping track of GDP and the economy’s growth. Each individual does not fully adopt and understand working with the money market. These shares also pay in profit in capital gains and a dividends way. The dividends payout does not add tax charges, as companies already pay the required tax. 

Disadvantages of a Cyclical Stock

As the economic factors promoting economic growth started slowing down, the bull market has also reached its peak, and now it has started reversing. When the bull market reverses, stock prices also start declining. In this scenario, a cyclical stock is the first to crash. When the economy enters a recession, economic growth slows down. 

During a recession, there is a massive decline in a company’s revenue and profits margins if the company’s products or services have cyclic demands. Therefore, it is plausible that the company may also start showing losses in its financial statements. 

It results in low free cash flow, which leads to periodic dividends. Due to these reasons, a  cyclical stock’s price tumbles and bottoms out, as the market has now rerated the value of the stock. The downgrade in valuation is due to the uncertainty surrounding the business’s capability to generate profits. 

The stock price of the cyclical stock will not give a significant run-up until the phase favorable economic conditions arise. However, it is impossible to predict how long it would take to see favorable economic factors again. Hence, a cyclical stock is a very risky investment compared to a non-cyclical stock.     

Cyclical Stock vs. Non-Cyclical Stock

Unlike a cyclical stock, a non-cyclical stock doesn’t get affected by macroeconomic changes in the economy. A non-cyclical stock, mainly defensive stocks, exhibits less volatility than a cyclical stock. Their price fluctuates a little over time and is more or less stable. Investors invested in such stocks receive regular dividends.  

As we know, the calculation of the beta in the defensive stocks. We can take the example of the Indian Stock Market, where stocks like Cipla, Infosys, and Bajaj Auto are examples of low betas. It means they don’t hold much higher value in the bull run. But the benefit of these stocks is that they are stable and less volatile than the higher beta stocks. Some of the higher beta stocks are ICICI Bank, Adani, and Paytm. They are high beta which tends to give riskier investments. These aggressive stocks are best for intraday trading. 

The underlying company manufactures and sells goods and services essential for day-to-day use. As a result, you can create a better portfolio. The cyclic stock is a chance to make your portfolio diverse and add some risk to the overall portfolio.  Investors can rely on defensive stocks to protect them from further losses. The market has multiple types of stocks. You can pick a group of defensive and cyclic stocks to invest in them for a stable portfolio.

Many major pharmaceuticals companies and medicine production companies can be cyclic stocks. The reason is the infinite need for medicine for humans. Medical aid is required in each situation of the market. But now, with the increase in too many pharma brands in the market, it is hard to choose healthcare defensive stocks and thus make it more prone to the risk factor of losing the stock value. 

Many companies in the stock market have matured over some time. Big companies such as reliance, Maruti, TATA, etc., come on a list of companies with potential business models. Even though these companies in the stock market may go through a correction period and the stock may also fluctuate, they will be back in line. These stocks also have had a good amount of growth over the past years. These stocks also provide you with a better return with less risk than the mid-cap companies and a better place to invest your savings.

The following points are some critical differences between cyclical and defensive stocks. 

• The performance of a cyclical stock highly depends on macroeconomic factors. However, macroeconomic factors do not influence the performance of defensive stocks to a great extent.  
• A cyclical stock is a lot more volatile when compared to defensive stocks.
• A cyclical stock is likely to outperform the broader market in a bull market. Likewise, they underperform the broader market in a bear scenario. At the same time, a non-cyclical stock tends to underperform in a bull market. However, they hold their ground and may even remain unaffected in a bear market. 
• Investors who invest in a cyclical stock can only make good returns once the stocks rally in favorable conditions. On the other hand, defensive stocks provide income to their shareholders through constant dividends. 
• The risk-reward ratio of a cyclical stock is higher than that of defensive stocks.

Conclusion

Investing in a cyclical stock can generate high returns during favorable economic conditions. However, they can generate no returns or even heavy losses if they invest in unfavorable conditions. It is impossible to time an economic cycle’s start, end, and length. Hence to mitigate risks, investors could diversify their portfolios. They should also keep themselves updated regarding macroeconomic trends. 

Besides, a bull market is when prices of most stocks, especially major stocks, rise for a sustained period. Likewise, a bear market is when the prices of stocks across the market decline. Both bull and bear markets last for months or even years.

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