Understanding Cyclical Stocks: Meaning, Benefits and How to Invest in Them
The business cycles and economic conditions in a country can impact the performance of the shares trading on the stock exchange. We can categorise stocks as cyclical and non-cyclical depending on how closely linked their performance is to the business cycles. For investors, this is beneficial in predicting returns and preparing investing strategies.
Let us understand the cyclical stock meaning and how you can invest in them.
What are Cyclical Stocks?
Cyclical stocks are sensitive to and move according to the economic cycles. Such stocks move from a phase of expansion to a phase of decline after peaking. After reaching their bottom-most point, they start recovering. Due to their movement in such cycles, they are termed cyclical stocks.
Cyclical stocks are typically the stocks of those companies whose core business is related to providing non-essential services or products. In periods of economic boom, there are lower levels of unemployment and higher per capita income. As household incomes increase, people spend and invest more and can allocate a part of their incomes to non-essential items, such as new furniture for their homes, an international trip, or even luxury products. This is when cyclical stocks perform well.
However, these stocks are most severely affected when there is an economic downturn. This is because the companies face an extreme reduction in the demand for their products and services as the income of households falls.
Reduced business activity affects the revenues and profits, which are reflected in the share price.
Which Industries Have Cyclical Stocks?
Cyclical stocks are common in the industries that provide products and services that are considered non-essential. That being said, cyclical stocks can be a part of many industries. Some of these include:
- Travel and tourism
- Luxury
- Automobiles
- Household durables
- Hospitality and dining
- Real estate
- Entertainment
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How to Identify a Cyclical Stock?
Identifying a cyclical stock involves a thorough analysis of how a stock has performed historically in different market trends. To make the task easier, you can shortlist the stocks of companies operating in a sector whose services and products are categorised as non-essential, as mentioned above.
Moreover, you can also identify a cyclical stock by analysing its beta value.
Beta value is a measure of risk that determines how sensitive stock is to changes in the market conditions. Cyclical stocks have a high beta coefficient. This means that they are typically more sensitive to changes and thus more volatile than other stocks.
Here is how you can calculate a stock’s beta value:
Divide the standard deviation of the returns that it gives by that of the overall market returns or the returns of a particular underlying index. A beta value of more than 1 shows comparatively more volatility in the stock than its underlying index.
How to Invest in Cyclical Stocks?
You can invest in a cyclical stock in the same way as you do for any other stock. Here is how the process of investing in cyclical stocks works:
Step 1: Open a Demat and a trading account in your name. Skip this step if you already have these accounts. Select a broker or an investing platform to be able to buy and sell shares.
Step 2: Identify which stocks fall in the category of cyclical stocks.
Step 3: Shortlist the cyclical stocks and analyse their performance. Select the stocks you wish to invest in.
Step 4: Decide the amount that you want to invest in the stock market, particularly on cyclical shares. Adding a few of such stocks to your portfolio helps in diversification.
However, remember that cyclical stocks are risky. This means that even though they have the potential to fetch you great returns when the economy is booming, the chances of losing money are also high in case there is a downturn.
Making sure that your overall portfolio is balanced is key.
Step 5: To purchase shares, you must place an order to buy them. There are various order types, including a market order, limit order, stop-loss order, and stop-limit order. However, the most common and basic one is a bid.
Here, you just have to mention the amount that you are willing to pay for a particular number of shares. Your order will be executed when the criteria are met.
When to Invest Money in Cyclical Stocks?
It is important to create a proper plan and strategy to get the maximum benefits out of your investments in cyclical stocks.
To find the best time to invest, you must take a look at the phase of the business cycle and the current economic scenario to gauge the performance of the cyclical stock. Apart from this, the returns that the stock gives and your risk appetite are the key factors to always keep in mind.
In situations of economic downturn or recessionary pressures, the cyclical stocks are at their lows. This can be a good time to invest in them.
As the economy starts to recover, the prices start moving up, and you can benefit by selling the shares at a higher price. If you are not looking at one-time capital gains and are seeking regular income through dividend payouts, consider investing in these stocks when the economy is moving up.
This is when household expenditure is rising, increasing companies’ income, thereby giving a surge to their profits. This enables companies to give out dividends.
Some particular instances that are most suitable for investing in cyclical stocks include the times when the Government is undertaking immense capital expenditure to boost the economy and when there is a huge economic capacity expansion.
Cyclical vs Non-Cyclical Stocks
Cyclical and non-cyclical stocks can be differentiated on the following basis:
1. Risk Involved
The risk involved in cyclical stocks is high, as the performance tends to move in phases of highs and lows. On the other hand, non-cyclical stocks remain fairly stable in their performance as they are not as highly affected by business cycle volatility.
2. Return
The return from cyclical stocks varies as per the business cycle. Such stocks have the potential to give very high returns in phases of growth; however, they are hit just as hard during economic downturns, showing a steep fall in returns. Non-cyclical stocks are bound to give consistent returns, as they are unaffected by major changes in business cycles.
3. Sector/industry
Cyclical stocks are typically of companies that operate in sectors producing consumer utility products. These also include the non-essential goods and services, as they are the first ones that consumers give up in case of economic distress.
Non-cyclical stocks come from the industries that are producing essentials, such as pharmaceuticals and the defence sector.
Cyclical shares have the following advantages:
1. Potential to Provide Higher Returns
The returns from cyclical shares can be very high when the cycle is moving favourably in an economic boom. If you invest in cyclical shares during such a phase, you can expect to see substantial returns. This happens because businesses see increased activity, which reflects positively on their shares.
2. Easily Identifiable
You can easily identify cyclical stocks by identifying the nature of the business of the company. Cyclical stocks are of those companies that provide non-essential goods and services, such as comfort goods and luxuries.
Moreover, you can analyse the trend of their stock market performance by comparing it with business cycles and see how they align.
3. Easy to Predict Performance
The stock market performance of a cyclical stock is in line with the business cycle operations. Even if you don’t have complete knowledge of the stock market, you can simply predict the performance of such stocks by understanding the business cycles. This can be done by looking at the major economic indicators, such as a country’s GDP.
Important Things to Know about Cyclical Stocks
You must keep these things in mind about cyclical stocks:
- Volatility: They can be highly volatile. Their performance depends on the country’s business cycles and economic conditions. Any event that negatively impacts economic functioning directly affects the performance of the cyclical stocks.
- Taxation rules: Keep in mind the taxation rules that come with holding cyclical stocks. Depending on your holding period, this can be classified into long-term and short-term capital gains.
Also Read: What Are Illiquid Stocks And How To Identify Them?
Final Word
Cyclical stocks are those that move in tune with the business and economic cycles. They usually are of the companies providing non-essentials. Such stocks have the potential to provide high returns but also involve higher risk.
Adding these to your portfolio helps in diversification and can fetch you great returns if you plan the investment well.
FAQs
Ans. Cyclical stocks are stocks that are sensitive to and move in accordance with the economic and business cycles of a country.
Ans. Cyclical stocks are common in the industries that provide products and services that are considered non-essential. For example, automobiles, travel and tourism, and entertainment.
Ans. The risk involved in cyclical stocks is high, as the performance tends to move in phases of highs and lows, as per the business cycles. Their value can fall sharply when there is an economic downturn.
Ans. In economic downturns or recessionary pressures, cyclical stocks are at their lows. This is a good time to invest. As the economy starts to recover, the prices start moving up, and you can benefit from a capital gain on selling your shares at a higher price.
Ans. Shortlist the stocks of the companies that operate in a sector that provides non-essentials. You can also compare their trends with business cycles and draw similarities. Calculating the beta coefficient of the stock is also a helpful tool.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
