Understanding cyclical stocks and their high risk – high return strategy
The world of finance conjures many images, one being that of a Ferris wheel. Economic cycles too seem similar to a Ferris wheel – constantly rotating as your investments sometimes fly high during the good times, and crash to abysmally low levels during downturns.
What are these economic cycles in the first place? Let us look at this in more detail.
Synopsis:
What are these economic cycles in the first place? Let us look at this in more detail.
Synopsis:
- Cyclical stocks are great investment opportunities
- They call for a high risk – high return strategy
- They follow economic cycles, and can be selected basis some indicators
- Price to book ratio, insider buying, cash reserves, and industrial cycles should be considered
Understanding economic cycles
A Ferris wheel completes a revolution within minutes. By contrast, the economic cycle takes years to spin, with distinct phases that can be observed before it completes a full revolution.
These phases can be broadly categorised as:
i) Growth or Expansion: In this phase, the economy experiences a growth in production, a low interest rate regime and a growth in prices.
ii) Peak: After the expansion stage, the economy hits a peak of growth, with production surpassing real demand.
iii) Recession or Contraction: The peak leads to a crisis due to the inability of the economy to grow further. Therefore, there is a slowdown in production, and a high interest rate regime is evident.
iv) Trough: This is the lowest point of the recession in an economic cycle, and the period has the lowest economic activity.
v) Recovery: With prices having fallen to their lowest ever, markets recover because of attractive valuations. In the broader economy, the recovery happens due to low prices as well.
What are cyclical stocks?
When the economic cycle is in an upswing, certain industries and sectors perform well, such as shipping, leisure, infrastructure and automobiles. During this phase, the demand for goods and services such as cement and power is on the rise.However, when the economy starts to decline, countries tend to reduce spending on such industries. The stocks of companies that produce such products and services, which are impacted by business cycles, are known as cyclical stocks.
Investment in cyclical stocks
Does it make sense to invest in cyclical stocks?
At first glance, they might seem to be a risky proposition, but the higher risk also holds the potential to give a higher reward on your investment.
Cyclical stocks can prove be a good medium term investment as they tend to outperform stocks of companies that show consistent performance when the tide of the economic cycle begins to change towards growth. However, timing is crucial, and one of the greatest tools that can be used to pick a great cyclical stock is the Price to Book Ratio, calculated by using the following formula:
Price to Book ratio = Stock Price/Total Assets of the company-Intangible Assets and Liabilities.
When prices are lower than the book value, there are chances that the stock may rise to coincide with book value. These stocks typically perform well during an economic recovery.
Another good indicator of a cyclical stock is insider buying. If a company’s management is busy buying its own stock, it could be an indicator for good times ahead for the stock you are considering.
Companies with good cash reserves are also a good pick. If a company is not capable of surviving a recession, it will certainly not qualify as a good investment decision.
Conclusion: As investment opportunities, cyclical stocks can be an important part of your portfolio. They present great investment opportunities for investors, who have an appetite to handle the higher risk.
The main risk is that when the economy is doing well, these stocks rise quickly, but when a recession sets in, cyclical stocks can tumble just as fast.
Studying the balance sheet of companies is important when you are looking to invest in cyclical stocks. It is also important to know the industry and the industrial cycle of the companies you looking to invest in, since each industry has its own cycle.
A Ferris wheel completes a revolution within minutes. By contrast, the economic cycle takes years to spin, with distinct phases that can be observed before it completes a full revolution.
These phases can be broadly categorised as:
i) Growth or Expansion: In this phase, the economy experiences a growth in production, a low interest rate regime and a growth in prices.
ii) Peak: After the expansion stage, the economy hits a peak of growth, with production surpassing real demand.
iii) Recession or Contraction: The peak leads to a crisis due to the inability of the economy to grow further. Therefore, there is a slowdown in production, and a high interest rate regime is evident.
iv) Trough: This is the lowest point of the recession in an economic cycle, and the period has the lowest economic activity.
v) Recovery: With prices having fallen to their lowest ever, markets recover because of attractive valuations. In the broader economy, the recovery happens due to low prices as well.
What are cyclical stocks?
When the economic cycle is in an upswing, certain industries and sectors perform well, such as shipping, leisure, infrastructure and automobiles. During this phase, the demand for goods and services such as cement and power is on the rise.However, when the economy starts to decline, countries tend to reduce spending on such industries. The stocks of companies that produce such products and services, which are impacted by business cycles, are known as cyclical stocks.
Investment in cyclical stocks
Does it make sense to invest in cyclical stocks?
At first glance, they might seem to be a risky proposition, but the higher risk also holds the potential to give a higher reward on your investment.
Cyclical stocks can prove be a good medium term investment as they tend to outperform stocks of companies that show consistent performance when the tide of the economic cycle begins to change towards growth. However, timing is crucial, and one of the greatest tools that can be used to pick a great cyclical stock is the Price to Book Ratio, calculated by using the following formula:
Price to Book ratio = Stock Price/Total Assets of the company-Intangible Assets and Liabilities.
When prices are lower than the book value, there are chances that the stock may rise to coincide with book value. These stocks typically perform well during an economic recovery.
Another good indicator of a cyclical stock is insider buying. If a company’s management is busy buying its own stock, it could be an indicator for good times ahead for the stock you are considering.
Companies with good cash reserves are also a good pick. If a company is not capable of surviving a recession, it will certainly not qualify as a good investment decision.
Conclusion: As investment opportunities, cyclical stocks can be an important part of your portfolio. They present great investment opportunities for investors, who have an appetite to handle the higher risk.
The main risk is that when the economy is doing well, these stocks rise quickly, but when a recession sets in, cyclical stocks can tumble just as fast.
Studying the balance sheet of companies is important when you are looking to invest in cyclical stocks. It is also important to know the industry and the industrial cycle of the companies you looking to invest in, since each industry has its own cycle.
posted by Yovan Shah at 10:53 AM
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