Understanding Cyclical Stocks

Cyclical stocks might be amazing during economic booms but risk is that if for any reason things get too bad and a recession stays too long, a cyclical stock might be forced out of existence.

If a recession was to happen in the next few months, what are the first items on your expense list that would be cut as a means to curtail spending? Would it be your television subscription, your luxury skin appointments or your quarterly trips out of the country?

There are different cycles in businesses and in life generally. Just like a company is expected to move through the cycle of growth, expansion, peak or boom, and ultimately a fall, the economy itself has its various phases that will always come and circle back.

While some stocks can survive in any economy like those tied to food and fast moving consumer goods (FMCGs) because of their necessity, some stocks would only be viable in peak economic periods.

Cyclical stocks are those securities whose prices are affected by changes in the macroeconomic landscape. They are those industries or businesses that consumers or clients would choose to cut down on when the economy is experiencing a down time.

Off the top of your head, you can imagine businesses tied to luxury traveling like a yacht service, expensive clothing stores, airlines, electronic or high-tech businesses, state-of-the-art restaurants, and so many more.

The risk here is that if for any reason things get too bad and a recession stays too long, a cyclical stock might be forced out of existence itself.

As a risk-averse investor, given the risks involved with cyclical stocks, you might be thinking, “why invest in these kind of stocks in the first place?” Here’s why:

Cyclycal stocks are what they are essentially because of the high value placed on them. What this means is that during strong economic periods, they tend to outperform the market. In essence, they are a key part of any well-balanced portfolio.

Investors need to be aware of the volatility at play with stocks like these. On one hand, these stocks can single-handedly change the entire value of your portfolio in a short period of time.

On the other hand, they can completely crash your portfolio my having terrible losses. Sometimes, these events can happen back to back. This then means that stocks under this title are a little tough to analyse.

How can you determine the expected growth in value or the stock price or really if it is a viable investment or not?

The first thing is to understand that timing the market is futile. Admittedly, because they are affected by the changing economic landscape, you might be tempted to time the market.

You might want to invest when things are down and the price of such stocks are lower and try to sell in a peak period. However, it wouldn’t take long before you realize that these stocks much like the entire market is hard to predict.

Research showed that during the last recession Nigeria faced in 2016, the sale of alcoholic beverages increased significantly. Heineken announced that organic consolidated beer volume grew by 4.6% across Africa and a few other regions, with Nigeria being a key driver of this growth.

You would expect that if a man lost his job he would spend less on such frivolities yes? Trying to trade cyclical stocks would not only be a very stressful activity, but you might also predict wrongly and lose money along the way.

This is why you need to be conscious of holding for the long term. Only then would your gains grow exponentially – with time.

This brings us to the best way to value such stocks. The best way is to determine the average earnings of the business over a period of years – say 7 to 10 years.

This works well because the period would have recorded the value of the business at different points and at different economic periods. With your valuation intact, you can now make informed decisions when valuing these stocks.

Written by Lawretta Egba.