Hand-Picked Cyclical Stocks Can Offer Good Returns
Cyclical stocks are easily the most misunderstood stocks in the equity market. Since most of them are large-cap stocks, novice investors are likely to confuse them with the relatively safer blue-chip stocks. Cyclical stocks can be broadly classified into two categories, the kind that are impacted by contractions or expansions in the economy, and the kind where the demand/supply dynamics of the product is governed by factors like pricing, earnings and cash flows. Auto companies, airlines, hospitality businesses, capital goods and banks fall under the former category. On the other hand, metals, chemicals, medicines and sugar comprise the latter. An important indicator of business cycles is the price of copper which increases when the economy is flourishing. In fact, the metal has been nicknamed Dr. Copper for its ability to forecast the economy and price movements.
The challenge with cyclical stocks is the difficulty in predicting their cycles. Generally, stocks with a low P/E multiple are considered attractive as it indicates higher earnings for the investment. However, this doesn’t hold true for all cyclical stocks as a very low P/E usually signifies the end of a favourable period. This is because the earnings escalate disproportionately in the upturn of the cycle. This is further followed by a cycle reversal, post which the stock declines and the P/E ratio adjusts higher.
Cyclical stocks have a high correlation to economic activity. They move in tandem with the business cycle and reflect the economic state. Contrarily, non-cyclical or defensive stocks remain relatively stable regardless of the business cycle and economic conditions. They exhibit consistent demand and are relatively immune to recession. This report aims to elucidate how cyclical stocks have performed with respect to defensive stocks. For the purpose of the study, we have selected the top stocks from five cyclical sectors namely – Airlines, Automobile, Real Estate, Sugar and Chemicals, as well as the top stocks from three defensive sectors namely- IT, Pharmaceuticals and FMCGs. We then collated the historical returns of each stock over three time periods – YTD, 3-year and 5-year, as this sheds light on both the short-term and long-term performance of these stocks. Finally, we computed the average returns for each DSIJ.time period and the results can be summarized as follows:
It is evident that defensive stocks fared better in comparison to cyclical stocks in the short-run. This is because the uncertainty prevalent in the market compelled investors to lean towards the more resilient defensive stocks over the impulsive cyclical stocks. The appetite for risk condensed in the face of unpredictability. The upcoming elections have created an atmosphere of speculation and volatility. In such times, investors are more inclined towards incorporating a degree of defensiveness in their portfolios. FMCGs are perceived as one of the safest defensive sectors with growth potential. Moreover, growth in disposable income of the burgeoning middle-class population gave a boost to this sector. Also, the Indian economy is linked with the global economy more closely than ever before. The deterioration of the Indian rupee against the dollar rendered companies with exports more attractive. IT and Pharma fall under this category as a major chunk of their earnings is in US dollars. As a result of these factors, defensive stocks outperformed cyclicals in the short-run. However, in the long-run, the performance of cyclical stocks surpassed that of defensive stocks by a substantial margin. This is because the cycles change with time and follow the ups and downs of the economy. Therefore, investors need to tread cautiously when considering cyclical stocks for their portfolio. The skill lies in selection and timing.
Identifying which cyclical stocks to purchase and when-
Cyclical stocks come with high risks and therefore, also the possibility of high returns. Ironically, it is unwise to purchase cyclical stocks when the company’s past financial performance is at its greatest. This is because a low trailing P/E ratio of a cyclical stock marks the end of its cycle. So, investors are under the illusion that they are purchasing cheaper when in reality the price falls upon the turn of the cycle. It could be years before the cycle changes again.
There are two ways of selecting cyclical stocks and timing plays a crucial role as these stocks are very volatile. Investors should buy these stocks at the bottom of their cycle, hold on to them on the roller-coaster journey to the top, and sell them when their cycle peaks. Needless to say, this is easier said than done because of the reactive nature of these stocks, particularly to negative news. This results in nerve-wracking fluctuations on the way up.
Another way is a method of elimination, wherein some less executed but more effective strategies are employed. This method involves choosing an industry that has completed major capital expenditure activities and is unlikely to add further capacities, steering clear of industries facing stiff competition from new entrants, relying on fundamental analysis to cherry-pick the finest companies, evading client concentration risk by choosing stocks that cater to a large client base and then narrowing down the list to stocks showcasing the most robust balance sheets and costconscious management, eliminating stocks with a D/E ratio above 1, refraining from paying greater than 1.5 times the book value and being prepared to invest for the medium-run (3-5 years) so as to allow the cycle to play out. Although the list is by no means exhaustive, it will certainly award informed investors an edge over others.
To recapitulate, investors must be mindful of three crucial points when investing in cyclical stocks, namely – entry and triggers, selection process and the exit. Investors must finalize the sector in which they wish to invest based on their comprehensive understanding of it. They should then shortlist a handful of stocks within that sector based on the aforementioned parameters and perform adequate stress tests to identify stocks that are likely to survive. It is intriguing to note that the best time to invest in cyclical stocks is when everything is going downhill – that is, when the return ratios are bad, EBITDA margins are down and the P/E multiple is either too high or negative. Thus, investors must take a contra approach and understand that these downsides are temporary. The ratios will undoubtedly improve upon the turn of the cycle.
Needless to say, due diligence about the sector is crucial. Furthermore, investors must be mindful of whether the cycle is going to turn. For example, in China, most capacities of chemical companies were shut down as they were excessively polluting; this marked the turn of the cycle for the chemicals industry. Another example involves the paper sector. Ballarpur Industries, the largest paper manufacturer of paper in India, shut down several plants. This resulted in a shortage of paper which drove the prices of paper up. This was a good trigger to pique the interest of investors. Identifying triggers for exit is just as critical. Even long-term investors must be very prudent about exiting at the right time; else the whole exercise will amount to nothing. Investors must exit when the stocks are delivering their best performance, such as selling when they are generating 6 to 8 times their peak earnings. Overall, two main guidelines investors must abide by are – to make positional plays and be acutely aware of changing cycles. Tracking supply is also of paramount importance.
It is critical to look at supplies when evaluating cyclical stocks. It makes sense to invest in cyclicals like sugar when there is a dearth of supply, as it leads to an increase in the price of the commodity. In such a scenario, the incremental price rise gets added to the stock's bottom line. However, the surplus sugar supply in the domestic market has dragged sugar prices down, resulting in poor profitability this year. This negative trend is likely to continue in 2019 as India is expected to increase its sugar production to satisfy internal consumption. This could be catastrophic as low sugar prices will meet with high values of sugarcane. This will not only squeeze margins but also affect millers' ability to pay farmers.
Conclusion
Presently, there are some external global factors that are impacting the Indian economy. However, some of these factors do not relate directly to the fundamentals of the Indian economy such as the recent strengthening of the US dollar against most major currencies, Fed raising rates, a relatively good performance of Oil prices as compared to the last two years etc. Moreover, the possibility of escalating trade wars between US and China and other major countries can pose a very significant geopolitical risk for the global economy. A trade war at such a large scale can push costs high due to new tariffs, in turn leading to inflation. Such scenarios can put pressure on the central banks to take hard decisions.
Even on the domestic front, there is a general concern in the investor community about earnings in the Indian economy. The Indian Rupee has been weakening rapidly. The uncertainty arising on account of the central elections has increased volatility in the market. As a consequence of these factors, the market has witnessed money flowing out of cyclical stocks into consumer defensive and export-based sectors such as Pharmaceuticals and IT. This presents investors with an opportunity to invest in cyclical stocks at attractive price points. As highlighted earlier, an investment into any cyclical stock needs to be made only after thorough research and even then, it carries a fair amount of risk. However, with current market dynamics, cyclical stocks remain a very good bet for a long term investment.