Cyclical Stocks To Do Well
Above average returns are possible in equity investments if one can catch the broader trend early. If 2020 was all about the defensive stocks, especially pharmaceutical and IT stocks, in all likelihood 2021 may belong to the cyclical sector stocks. A change in portfolio stance is all that is required in order to outperform the markets in 2021, from defensives to cyclical stocks. Yogesh Supekar explains what exactly ‘cyclical stocks’ are and discusses why cyclical stocks may do well in 2021
Active investment management is all about strategic and tactical portfolio management decisions. Strategic portfolio management decisions are usually those which are made keeping a long term investment horizon in view and also includes decisions on asset allocation. For example, keeping 60 per cent exposure in equity and 40 per cent exposure in bonds is an example of strategic asset allocation. Tactical decisions are made keeping in mind short to medium term tenure. For example, giving higher weightage to private banks with a 12-18 months’ kind of timeframe is a tactical portfolio decision.
Those active investors who could assess intelligently, and early, sectors that would remain pandemic- proof have easily made tons of money in 2020. Clearly, IT and pharmaceutical stocks showed a superlative performance in 2020 and those investors who were tactically well-positioned for such a move have reaped great rewards for taking the right portfolio decisions.
In the investing world cyclical stocks are those whose fortunes swing as per the business cycle of an economy.
Says Chetan Tupe, an active HNI investor: “I have always been a big fan of IT stocks. If you study the historical performance of the sectoral indices in India, it is the IT index along with banking and FMCG indices that has generated the best returns.”
“It was not very difficult, after the lockdown was announced, to understand which sectors would do well and which may not. The pharmaceutical sector obviously was an easy bet along with IT stocks. I simply increased the weightage in pharmaceutical and IT stocks while reducing the weightage in financials and banking stocks. Defensives usually do well when the markets are going through a tough period. Such tactical moves always help to generate above average returns,” he adds.
Tupe further states: “Now I am reducing my portfolio weightage in defensives and increasing my holdings in those sectors that promise rapid recovery, including banks and financials. It is profitable to remain active and rotate within sectors or else I am afraid one may never outperform the key benchmark indices such as the Sensex and Nifty. The thing is: money can buy happiness if you invest right. To invest right it is important that we catch the underlying trend as early as possible and make tactical adjustments in the portfolio.”
Indeed, portfolio positioning and weightage matter if one has to outperform the markets consistently. If we closely look at the underlying trend in the recent trading sessions, clearly the so-called cyclical sectors and stocks have started to outperform the defensives and the key benchmark indices. The table below highlights the outperformance by defensives in 2020 and the relative outperformance of cyclical sectors in the past one month.
The question most investors need an answer to is whether the cyclical stocks will continue their outperformance in the coming months and in 2021 as well. Before we can be sure if the cyclical stocks will outperform or not, it is important to understand what cyclical stocks are and how they perform when the economy is in a recovery mode. The Sensex is positive in 2020 in spite of the pandemic hitting us. However, the movement in stocks has not been secular. Stocks from particular sectors such as technology and pharmaceutical have shown huge outperformance, highlighting the polarised movement in the markets. A study conducted by CLSA highlights the fact that only 15 per cent of the universe of pandemic-impacted stocks are above the pre-pandemic levels. This data highlights the underperformance of impacted stocks since as many as 70 per cent of the pandemic-resilient stocks have surpassed their respective pre-pandemic stock prices.
Understanding Cyclical Stocks
Cyclical stocks are the ones whose fortunes are closely related to the economic conditions prevailing globally and in that particular country. They tend to do well when the economy is in an uptrend while they move down when the economy is in a downtrend. It is not unusual to see higher trading interest among investors in cyclical stocks as investors tend to but these stocks at the low point of a business cycle and sell them at the high point of the same business cycle. Cyclical stocks on an average are more volatile when compared to the defensive bets and can be characterised as high beta stocks.
Shares of consumer discretionary companies are normally considered to be cyclical in nature as it is normal to expect consumers to buy the products of the discretionary companies in a booming economy while they may cut down on their spending or consumption during a recession or economic slowdown. Automotive stocks, companies operating in the aviation sector, textile, hospitality, financials and banks, capital goods and luxury goods makers can be termed as cyclical in nature. Private sector stocks in India though are considered to be defensive these days as their business models have been tweaked so that the earnings are not impacted by the economic slowdown and movements.
These so-called cyclical stocks witness a jump in profits in a booming economy while these are the same companies that witness a steep drop in profits during an economic slowdown. Cyclical stocks are often considered to be risky because of their volatile nature and high beta values. They often tend to have volatile earnings per share (EPS) as the earnings keep on fluctuating as and how sentiments get affected, factoring in ground realities in the economy. Another characteristic of cyclical stocks is that they tend to reflect low PE ratios and hence are almost always cheaper when compared to the defensive stocks.
The shares of companies that are more closely linked to the economy are called cyclical shares while the shares that are not affected by economic trends are called defensives.
The ideal time to invest in cyclical stocks is at the beginning of any business cycle. Times such as now when governments across the globe are announcing fiscal packages i.e. adopting expansionary fiscal policy can be perfect for investing in cyclical stocks. Investing in cyclical stocks at the base of a major capital investment cycle can prove to be extremely profitable. As an investor, the realisation about capacity addition in the economy would be an ideal time to hunt for cyclical stocks. One may argue that there is hardly any capacity expansion happening in the economy. However, with the government stimulus and increase in infrastructure spend the economic uptrend may get a fillip.
Suman Chowdhury
Chief Analytical Officer, Acuité Ratings and Research
The significantly lower YoY contraction in Q2GDP at 7.5 per cent vis-à-vis 23.9 per cent in Q1 has been largely in line with our expectations given the effect of pent-up demand in the economy after a protracted lockdown in large parts of the country. The agriculture sector continues its good run with 3.4 per cent growth and the manufacturing sector has also slightly surprised with a growth of 0.6 per cent. Further, the electricity sector has shown a healthy trajectory with 4.4 per cent growth mainly due to a pickup in household demand and nationwide electrification. However, the services sector continued to witness significant challenges at -11.4 per cent YoY, particularly in financial services and in segments such as retail, hospitality and tourism.
What has really supported the GVA and GDP in Q2 is the performance of the private sector which has recorded moderate earnings growth through significant cost optimisation despite the pandemic- related challenges and slowdown in revenues. Going forward, however, we believe that the revival momentum in Q3 and Q4 will be critically dependent on the pickup in private consumption during the festive season and a reduction in the intensity of the pandemic. Any further resurgence of the pandemic and the delay in the introduction of the vaccines may constrain the expected GDP growth in Q3 and Q4.
The growth in cyclical stocks is hugely dependent on the growth in economy and a combination of investment and growth in the economy can push cyclical stocks higher, thus generating above average returns. This very quintessential trait of cyclical stocks makes it absolutely necessary to add them to the portfolio. Because of the nature of cyclical stocks and their behaviour, timing is extremely essential when one is buying such stocks. Timing matters in equity investing; however, it matters much more when one is buying cyclical stocks. Some analysts categorise cyclical stocks into the rate-sensitive and commodity-based sectors.
In the rate-sensitive sector the businesses are primarily affected by the interest rates prevailing in the economy. Banks, capital goods and automotive companies are some of the examples of rate-sensitive sectors that are cyclical in nature. Metals and mining, sugar and cement companies are examples of commodity-based sectors that are cyclical in nature. It is observed that cyclical companies suffer huge losses during recessions. When the economy shows improvement, it is usual to see these cyclical stocks declare huge swings from profits to losses. One of the other important factors that affect the performance of the cyclical stocks is various regulative and administrative policies.
Cyclical stocks are largely dependent on economic growth.
Investing in Cyclical Stocks
One of the reasons why investors invest in cyclical stocks is because of the huge opportunity to book profits if one is able to catch them at the start of a new business cycle and exit at the peak of the same cycle. These business cycles tend to repeat themselves and hence provide excellent investing opportunities. One of the tricks to investing in cyclical stocks is to pick an industry that is expected to revive itself. The point in case is the current status of the automotive sector as well as the banking sector in India post the lockdown. Interest rates also play a crucial role in the overall quality of economic recovery.
Declining interest rates and consumer spending signals economic expansion and this phase is best for investing in cyclical stocks. Similarly, when the interest rates are rising and the consumer spending is declining, it is one of the best times to exit from cyclical stocks. Also, one has to keep an eye on the regulatory issues that hit the industry. For example, cement pricing for cement stocks, sugar price control for the sugar industry, etc.
According to Credit Suisse, cyclical stocks are expected to deliver a surge in profit growth next year. It projects that cyclical sectors will report more than 65 per cent earnings’ growth next year in the US markets.
Conclusion
The rally of the markets may continue in the coming months even if this year’s November has been one of the best months for the equity markets. Yes, the Sensex and Nifty are slightly in the overbought zone and so are Bank Nifty and several private banking stocks. In fact, the outperformance of Bank Nifty in November over Nifty is at its historical high. The minor pause in the short term is always a possibility; however, the rally may have more legs to it than many believe. One of the strongest reasons for the rally to continue is the fact that the cyclical stocks have just started to do some catching up while the economy attempts to recover from the shock of the pandemic.
It was the category of defensives that pushed the key benchmark higher in 2020 but in 2021 it could well be the cyclical stocks i.e. automotive, realty, banking and capital goods that push the key benchmark indices higher. While cyclical stocks are expected to outperform owing to the broad-based recovery in the economy, it is not that the defensives are expected to deliver negative returns. IT and pharmaceutical stocks are expected to deliver strong growth in earnings while the cyclical stocks do the catching up. Overall, the markets may continue to build gains from the record highs with a much bigger contribution from the cyclical stocks. On the valuation front, at around 18x PE on normalised FY22 earnings per share the index does look a little stretched. Valuations hint that the upside may be capped.
"You can't go to sleep holding cyclical stocks for a decade and expect to be richly rewarded. The rich rewards are in growth stocks and special situations."
- Peter Lynch
"My experience teaches me that by far the largest losses have been sustained by investors through buying securities of inferior quality under favorable general conditions."
-Benjamin Graham
We are very close to the 15-year high PE multiple. That said, the emerging markets are in a sweet spot with the global economy all set to be normalised in 2021 with more and more countries opening up for business after a prolonged lockdown. The free movement of goods and services in 2021 will be a huge trigger for the growing economies of emerging markets. With the uncertainty over US’ presidency out of the way, positive results expected on the vaccine front and the stimulus expected to be announced in developed economies, the emerging markets will be expected to outperform even as the FPIs may continue to invest incrementally in emerging markets with a preference for Indian equities along with other Asian equity markets.
Cyclical stocks may be lowrisk and high-gain or highrisk and low-gain depending on how adept one is at anticipating business cycles.
Going ahead, the global economy faces a Catch 22 situation. Mobility is the key to economic recovery and at the same with increasing mobility there remains the risk of escalating corona virus cases. With rising cases mobility can drop drastically. That is why the development on the vaccine front will be closely monitored by market participants across the globe. Any positive news on the vaccine front will act as a trigger for the markets even though most of the positives could already have been discounted in the current stock prices as far as vaccine development goes. Investors will be keenly watching the RBI decision on interest rates. With the inflation expected to inch up, the interest rate cuts may take a pause. RBI has done enough rate cuts in 2020 and investors can build a case assuming the interest rates may not head further down south in 2021.
Overall, the sentiment is expected to remain positive and the focus in 2021 will be purely on economic recovery, the government’s stimulus package and the quality of earnings. Such an opportune environment and relative underperformance of cyclical stocks in recent years suggest a tremendous potential catch-up rally in the cyclical stocks. Investors can take a 12-18 months’ view on cyclical stocks to outperform the markets. The biased stance towards such stocks may yield higher returns. However, the defensives should not be ignored in 2021 as IT and pharmaceuticals continue to dominate the list of sectors with highest growth in earnings.