Investing in cyclical stocks has notable advantages and disadvantages. Of course, despite the risks involved, adding them to a portfolio of stocks can help an individual reduce the overall risks of investing in stocks while also maximizing the return potentials of the entire portfolio regardless of the market condition and economic situation.
Key Characteristics of Cyclical Stocks
Identifying the Right Stocks that Would Perform Well During Economic Expansion
Cyclical stocks represent a specific type of stocks that tend to follow the ups and downs of the economy or the boom and bust phases of the economic cycle. These stocks perform well during periods of economic expansion but their value depreciates during a recession. The following are its specific characteristics:
• Usually Have High Beta: These stocks tend to have a high beta. This means that they are usually more volatile than other types of stocks such as growth stocks and value stocks and the overall stock market and even the stock index. This comes from the fact that the value of these stocks tends to follow the fluctuations in the economy.
• Economic Sensitivity: Cyclical stocks are sensitive to the condition of the economy. The value of these stocks tends to appreciate during economic expansion or periods of positive economic growth but then depreciate during periods of recession. The performance of these stocks follows the boom-and-bust cycle of the economy.
• Volatile Earning or Value: Another notable characteristic of cyclical stocks is that their earnings or value tend to be volatile. Remember that the performance of these stocks tends to follow the boom-and-busty cycle of the economy. Their value is essentially tied to the overall performance of the economy and their respective industries.
• Industry Concentration: These stocks are concentrated in specific sectors and industries that are sensitive to economic conditions. Examples include the consumer discretionary sector which includes the automaking and consumer electronics industries, the construction industry, and producers and suppliers of basic materials, among others.
• High Capital Expenditure: Companies that issue these stocks also tend to have high capital expenditure requirements. This comes from the fact that they may need to invest heavily in new equipment, facilities, and research and development during economic expansion to expand their businesses to accommodate high demand.
• Variable Dividend Policies: These stocks can also be dividend-paying stocks. However, because their value is volatile, they tend to have variable dividend policies than non-cyclical stocks. Some of these stocks may pay high dividends during economic expansion but may cut or eliminate dividend payouts during economic downturns.
• Opposite of Defensive Stocks: Cyclical stocks are the opposite of defensive stocks. Note that defensive stocks tend to be stable during periods of economic downturns while the value of cyclical stocks tends to depreciate under the same economic condition. Defensive investing provides lower returns but is less risky.
Important Tips and Reminders for Spotting and Choosing the Right Cyclical Stocks
Remember that investing should be intentional. It is true that investors can earn from investing in stocks and that one of the benefits of stock investing is hedging against inflation but it is also true that a lot of investors end up losing money from wrong investment decisions.
Adding cyclical stocks to a stock portfolio can help in spreading and reducing the impact of economic downturns on portfolio performance and investment returns. The following are important tips and reminders for investing in cyclical stocks:
• Ask Key Investment Questions: You should understand the reason behind your investment decision. It is important to ask yourself the essential questions before you invest in cyclical stocks. These include probing your purpose, how much you are willing to set aside, and knowing your risk profile, among others.
• Look for Record of Performance: Invest in companies with a track record of strong performance during economic expansions. This record includes historical stock prices, earnings growth, and revenue growth during economic booms. This is fundamental to understanding how well they perform during previous economic cycles.
• Know the Sector and Industry: Make sure that you understand well the dynamics within the specific sector or industry of your chosen companies. Look for trends across an entire sector or industry. Understand the entire competitive landscape which includes the intensity of rivalry and threats of new entrants and substitutes.
• Look for Price Leadership: Companies with strong price leadership have stronger bargaining power against consumers and tend to influence pricing trends in their respective industries. They tend to weather economic downturns more than those with weak price leadership, and their revenues remain acceptable during downturns.
• Monitor Macroeconomic Indicators: Keep an eye on economic indicators such as GDP growth, employment rates, and consumer spending. These macroeconomic indicators can provide insight into the health of the economy while providing you with relevant cues as regards the proper timing of investing in cyclical stocks.
• Remain Patient But Vigilant: Recovering from a recession can take years. This means that investing in cyclical stocks should involve holding periods that can last as short as two years or as long as three years and more. It is important to be patient while also remaining vigilant about macroeconomic and industry-wide trends.