It is important for investors to be able to distinguish which stocks on the Australian share market are “cyclical”. At certain phases of the economic cycle, cyclical stocks can under or overperform the market. This means that by identifying where we are in the cycle, and identifying which stocks are cyclical stocks, an investor can improve their portfolio returns.
What are cyclical stocks?
Cyclical stocks are stocks that move with the economic cycle. This means these stocks are affected by, and heavily correlated to, the economy.
When should you buy cyclical stocks?
When the economy is moving to a stronger position, investors should think about investing in cyclical stocks. This is because these stocks will be the ones to benefit from the strength of the economy. Defensive stocks are better performers when the economy is in a recession.
Why are they important now?
Our opinion is that global growth is bottoming which means that economic growth should now be entering an uptrend. All the talk of recession and the economy weakening appears to have not played out in reality, hence confidence in the market is returning. When the economy is in this phase, investors can take advantage of this by investing in stocks which consumers will buy when they have more confidence in the economic future.
What are some examples cyclical stocks?
Consumers will have more confidence to spend money on non-essential items such as apparel. When the economy is in a weak state such as a recession, people will hold off spending on items which are not necessary. Retail is a good sector to buy into when the economy is strong as people will be less frugal with their money and spend it on items which they want as opposed to just items they need.
People may be more willing to spend money on buying a new car when the economy is robust and they have extra income. In a recession, people may be concerned about losing their job and are unlikely to splurge on a new expensive car.
Consumers will be more comfortable taking a holiday when the economy is secure again. Hence travel companies involving hotels and airlines will see a pickup in business in economically strong periods.
When economic growth starts to increase, the demand for raw materials will also increase as companies start looking to expand again and so does the demand for resources.
The manufacturing and Industry sector will benefit from an uplift in economic growth. This sector is focused on transforming raw materials into finished products. If consumers are feeling more confident with the future and spending more of their disposable income, then it means their demand for goods are increased which translates to more demand from manufacturing companies.
Banks are cyclical stocks as they also move in line with the economy. When the economy is weak, people are less likely borrow money from the bank to expand their businesses or to borrow to purchase luxury products such as the new car. In a recession, banks are at risk of borrowers defaulting on their loans which can decrease their share price. Hence banks perform better when the economy is strong.
What are the characteristics of a cyclical stock?
Cyclical stocks are riskier than defensive stocks. They usually have a beta of more than 1 which means their share prices can move more than the broader marker. Defensive stocks have a beta of less than one which indicates their stock performance is less affected from a market downturn. The earnings of a cyclical stock fluctuate with how the economy is performing so they do not generate stable revenues like defensive stocks. This characteristic also makes the price to earnings ratio lower for a cyclical stock as investors are paying a premium to invest in defensive companies with their stable revenue streams.
Lauren Hua is a private client adviser at Fairmont Equities.
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