Investing in cyclical stocks can be a volatile but lucrative strategy. As many investors have recently learned, the economy doesn’t grow in a straight line. Instead, it’s much more like a wave moving up to a peak and then down to a trough, repeatedly.
This is better known as the economic cycle. It has four distinct stages:
- Expansion – Sustained growth creates a favourable environment for businesses but eventually creates inflation
- Peak – Growth reaches its maximum point, exposing imbalances in the economy that need correction, such as high inflation
- Contraction – Growth slows or sometimes even reverses, causing the economy to cool down, which can sometimes trigger a recession, but typically enables inflation to drop to healthier levels
- Trough – The economy reaches its lowest point and begins to recover, starting a new period of expansion
In 2022, a prolonged period of expansion came to a close. Central banks like the Bank of England and the Federal Reserve have begun increasing interest rates to combat runaway inflation. And the economy is now nearing the contraction stage of the cycle.
The degree of severity of the incoming economic slowdown is not yet known. While there is the possibility of a recession, it’s not a guarantee. However, the stock market despises uncertainty. And for many cyclical stocks, this has created enormous market volatility.
What are cyclical shares?
Cyclical shares are businesses and industries that are strongly correlated to economic growth. They can drastically outperform the stock market during a period of expansion. However, when contraction eventually appears, they’re more likely to underperform.
Companies can also have their own unique business cycles. For example, travel stocks tend to see sales pick up around the summer and winter holidays.
Investors capable of successfully identifying these businesses’ profit and sales cycles could achieve impressive returns. However, the duration of each stage can vary drastically each time around. And that makes trying to perfectly time a cycle a loser’s game.
Cyclical vs non-cyclical stocks
Not every company follows the economic cycle, of course. There are plenty of businesses whose products remain in demand even when consumer spending is trending downward. These are known as non-cyclical, secular, or defensive stocks.
Some examples are consumer staple retailers or healthcare providers. After all, regardless of whether prices are rising, people need access to food and medicine.
Examples of cyclical sectors
There are some exceptions for companies within each market sector. But generally speaking, the majority of firms operating in these industries are cyclical stocks.
- Airlines – During economic recessions, consumers and businesses are less likely to spend on air travel
- Automotive – New and used vehicle sales tend to drop off during contraction and pick up again during expansion
- Construction – Most construction projects are funded using debt financing, which is typically more expensive during contraction as interest rates are boosted to tackle inflation; therefore, projects are often delayed or put on hold until the money supply is less restrictive
- Consumer Discretionary – Rising interest rates often slow consumer spending, resulting in discretionary spending dropping off
- Finance & Banking – Finance businesses sometimes have mixed responses to periods of economic downturn — rising interest rates enable lending activity to become more profitable, however, the higher cost of debt makes selling new loans more challenging
- Industrial Equipment – Sectors like airlines, automakers, construction, and manufacturing all suffer during contraction, and companies involved in designing and producing the equipment used by these industries tend to suffer from a domino effect resulting in lower sales and demand
- Luxury Products – Similar to Consumer Discretionary, when money is tight, sales of high-end fashion, diamond jewellery, and luxury watches tend to fall during contraction
- Manufacturing – During expansion, companies that manufacture products often see demand skyrocket; unfortunately, the opposite is true during contraction
- Mining – Mining stocks are highly susceptible to the movement in commodity prices, as demand for raw materials tends to climb during expansion, resulting in higher profits; however, when contraction occurs, the reduced throughput of manufacturing firms causes demand for raw materials to suffer and commodity prices to fall, directly impacting the profitability of this industry
- Real Estate – Liked to the banking industry, when interest rates are increasing, mortgages become more expensive, which directly impacts home affordability, typically resulting in fewer consumers seeking to buy a new home
- Travel – Similar to airline stocks, hotels and cruise line businesses tend to suffer during contraction from lower consumer spending on travel
Top cyclical stocks in the UK
|Rio Tinto (LSE:RIO)||£79.95bn||Mining||Global mining company operating in 35 different countries, expanding into lithium mining for electric vehicles|
|InterContinental Hotels (LSE:IHG)||£6.72bn||Travel||An operator of essential, premium, and luxury hotels worldwide|
|Burberry (LSE:BRBY)||£6.72bn||Luxury Products||One of the oldest luxury fashion brands in the world, dating back to 1856|
|Trainline (LSE:TRN)||£1.83bn||Travel||Runs an online platform that enables travellers to find and buy tickets for trains and coaches across Europe|
|Motorpoint (LSE:MOTR)||£175.87m||Automakers||A used-car retailer focusing on the nearly-new market segment|
Rio Tinto is a global leader within the metals and mining industry. The group engages in the exploration, development, and production of critical materials. With a diverse portfolio of extraction sites, the group specialises in iron ore, aluminium, and copper, as well as precious minerals such as borates for wood treatment and diamonds for jewellery.
With the rise of renewable energy technology and electric vehicles, the demand for lithium has skyrocketed. And this trend is expected to continue for the foreseeable future. Consequently, management has begun to invest in developing new mining sites focused on the extraction of lithium from the Earth’s surface.
- Market cap: £79.95bn
- Average daily volume: 3.04m
- HQ: London, UK
- Cash/debt: $15.3bn/$13.5bn
InterContinental Hotels is a hospitality conglomerate operating 6,000 hotels around the world under 17 different brands. The list includes Crowne Plaza, Holiday Inn, Six Senses, and Hualuxe. Each one caters to different types of budgets and desires, from cheap and cheerful overnight stays near airports to luxury five-star villas in Bora Bora.
- Market cap: £8.83bn
- Average daily volume: 562.36k
- HQ: Denham, UK
- Cash/debt: $1.5 bn/$3.3bn
Burberry is a designer, manufacturer, and retailer of luxury fashion. Since its inception in 1856, the group has transformed itself into a premium brand, building a reputation for quality, especially after inventing a unique weatherproof cotton fabric called gabardine.
Today the company operates out of 220 retail stores, 142 concessions, 57 outlets, and 38 franchisees.
- Market cap: £6.72bn
- Average daily volume: 1.74m
- HQ: London, UK
- Cash/debt: £1.2bn/£1.4bn
Trainline is a digital technology business operating within the travel industry. Its mobile app and website allow travellers to find, compare, and buy tickets for trains and buses across Europe.
The group works directly with over 270 rail and coach operators to display and sell the best offers to over 30m travellers on its digital platform. Its mission is to become a one-stop shop for all rail and coach travel.
- Market cap: £1.83bn
- Average daily volume: 938.14k
- HQ: London, UK
- Cash/debt: £68m/£153m
Motorpoint is an independent e-commerce and brick & mortar vehicle retailer based in the UK. The group only sells used vehicles. But management specifically focuses on the nearly new segment of the used car market. The result is consumers can purchase almost brand-new vehicles at significant discounts.
Beyond catering directly to consumers, the firm also operates an online wholesale platform to tap into the business-to-business sales market. By securing vehicles through part exchanges, the firm has been able to keep up with demand without seemingly sacrificing quality, receiving multiple awards throughout its lifetime.
- Market cap: £175.87m
- Average daily volume: 75.96k
- HQ: Derby, UK
- Cash/debt: £7.8m/£229m
How to identify cyclical stocks
It’s entirely possible to have cyclical stocks in non-cyclical industries and vice versa. So, being able to identify whether a business falls under this category is important in regard to portfolio diversification.
Fortunately, being able to spot these companies isn’t particularly challenging. The easiest method is to look at the year-on-year sales performance over the past decade. Suppose the revenue stream has been consistently rising over long periods. In that case, the odds are that it’s a non-cyclical company.
However, in rare cases, cyclical companies can hide their true nature through acquisitions and contract timing, requiring a more thorough investigation.
Similarly, the same top-line analysis method can be used on quarterly revenue data to identify individual business cycles. Suppose a pattern consistently emerges that a group is generating more sales during a specific part of the year. In that case, this is likely a cyclical company.
How to invest in cyclical stocks
Buying and selling shares of a cyclical business work identically to any other industry. However, when it comes to making a smart investment, there are a few traits to look for.
Historically, economic contractions can last anywhere from a few weeks to several years. During this time, cyclical companies need to be capable of weathering the storm.
While revenue and earnings will continue to flow during these unfavourable conditions, they will be at a reduced rate. And for firms with next-to-no control over their operating expenses, this can create a lot of problems.
For example, the expenses of mining companies are predominantly fixed. This cyclical sector thrives when raw material prices are high as it paves the way for exceptional profit margins. But when prices are low, it can quickly push a once-thriving business into the realm of unprofitability.
That’s why it’s essential to check the state of the balance sheet for cyclical businesses. In my experience, the best cyclical shares to buy are the ones with strong liquidity and a large cash war chest.
Having immediate access to capital as and when needed helps eliminate most insolvency concerns. But more interestingly, it reduces the group’s reliance on external financing during a time when raising additional capital is much more expensive.
Are cyclical stocks right for you?
Investing in cyclical stocks can generate substantial returns during times of economic growth. Therefore, including this class of investment into a portfolio is a worthwhile venture. However, it’s important for an investor to diversify across multiple industries, both cyclical and non-cyclical as well.
This combination approach allows investors to become better positioned to capitalise on growth during the good times and mitigate the downside during poor economic conditions.