What are cyclical shares? Definition and meaning
Cyclical shares, also known as cyclical stocks, are those that go up and down in value in tandem with the country’s economic performance.
When GDP (gross domestic product) grows strongly, the shares appreciate significantly, and decline in value when the economy is doing badly.
The opposite of cyclical shares are defensive shares, which perform better when times are hard, but less impressively than cyclical stocks during an economic boom.
Most shares are cyclical to a certain extent and will follow global, national and/or regional economic trends.
When investors refer to cyclical shares they are specifically talking about companies whose profits are very closely tied to the way the national economy moves.
Real Estate Investment Trusts (REITs) and property developers tend to shadow the national economy’s performance, which means their shares do too. When the economy is growing demand for property generally rises, and falls during a recession.
Bank shares are also cyclical. During an economic boom people borrow more, which means more business and thus profits for banks. When an economy is growing strongly banks tend to charge more. Conversely, poor GDP growth or economic contractions affect bank shares, bringing their prices down.
The graph above shows how the automobile and beverages sectors behave according to the US economy. Auto shares (more cyclical) fell more sharply during the two recessions than the beverage shares (more defensive). (Data source: Société Générale S.A.)
The shares of companies that sell discretionary items – ones that consumers can afford to purchase more when the economy is booming – are cyclical.
Discretionary items are non-essential goods, such as apparel, new automobiles, jewelry, entertainment, gourmet meals, and vacations abroad – they are the opposite of essential goods.
When people are worried about their jobs, they hold onto their cars for longer before replacing them.
IT firms are also cyclical. Companies are more reluctant to invest in renewing their computer systems during a recession. Most will postpone such expenditure until the economy picks up.
The opposite of cyclical shares are defensive shares (defensive stocks). Defensive shares do not follow the national economic cycles, because they belong to companies that sell products and services that people need all the time.
Examples of defensive shares include those issued by utility companies – electricity, gas and water. Sellers of basic household goods such as toilet paper, toothpaste, bread, and milk tend to have sales that are immune to economic cycles, compared to other businesses.
The shares of healthcare companies, funeral services and telecom providers are also defensive.
Even the shares of cigarette makers are defensive – most smokers are addicted and will usually find the money to get their cigarettes, regardless of their financial situation.
What should a portfolio have?
A good investment portfolio should contain both cyclical and defensive shares. The two types have their potential merits, and their relative balance depends largely on the investors’ market view, how much risk they are comfortable taking, and requirements for dividends.
Experts say that in general growth funds tend to tilt towards cyclical shares while equity income funds have a higher proportion of defensive stocks.
The Telegraph quotes Justin Modray, of Candid Financial Advice, who said:
“In general, since it is difficult to predict the future, it makes sense to hold both types of stock in your portfolio, either directly or via fund managers who tend to favor one or other styles of investing.”
What to do during the cycle
Clever investors will try to identify where in the economic cycle their national economies are, and switch their stock mix accordingly.
If it looks as if an economy has reached the end of a recession and things are picking up, they will probably increase their proportion of cyclical stocks and reduce their volume of defensive stocks.
Professional investors and portfolio managers regularly study the ‘Purchasing Managers Index’ (PMI), which can point to how healthy or unhealthy the economy is. The PMI contains economic indicators derived from monthly surveys of private sector companies. If the PMI rises it usually means that economic activity is going to increase, and will decline if it falls.
French multinational banking and financial services company Société Générale S.A. says the following about cyclical stock:
“A cyclical stock is a stock highly correlated to the economic activity. When the economy is in a recession the profits of a Cyclical company tend to drop and so its share price. Conversely, when the economy is in a good shape (expansion), the share price tends to goes up with the profit growth.”
Barry Ritholtz, an American author, newspaper columnist, blogger, equities analyst, and guest commentator on Bloomberg Television, said:
“Owning a variety of asset classes means that some part of your portfolio will be doing well when the cyclical turmoil arises. A broadly diversified portfolio includes large capitalization stocks, small cap, emerging markets, fixed income, real estate and commodities.”