Unveiling the Truth About Cyclical Stocks: Why They Aren't a 'Forever' Bet and How They Really Work!

Karan Dsij
/ Categories: Trending, Knowledge, Fundamental
Unveiling the Truth About Cyclical Stocks: Why They Aren't a 'Forever' Bet and How They Really Work!

When do cyclical stocks outperform and underperform?  

Hold on tight, because if you thought roller-coaster rides were thrilling, wait until you get a load of the stock market! And when it comes to investing, there's nothing quite like the heart-pumping rush of investing in cyclical stocks. These stocks are like a never-ending thrill ride of ups and downs, sudden turns and unexpected drops, that can leave even the most seasoned investors feeling dizzy.

But what exactly are cyclical stocks, you ask?

According to investing legend Peter Lynch, cyclical companies are those whose revenues and profits are tied to the state of the economy, and whose performance is closely linked to the business cycle. And believe it or not, they make up a whopping three-quarters of our markets, extending beyond just commodity products like steel, copper, and chemicals, to include automobiles and consumer durable goods.

When do cyclical stocks outperform and underperform?  

Cyclicals can offer fantastic returns during times of economic prosperity; they can also plummet during recessions or periods of economic turmoil. Cyclicals can be great investments when the economy is growing, but they are not a forever bet. Investors need to be prepared for the ups and downs of the ride.  

What makes investing in cyclical stocks such a challenging task? 

Commodity cyclicals can be one of the most challenging sectors to analyze, comprehend and profit from due to the market participants' inability to accurately predict the movement of underlying commodity prices, which influences the fluctuation in the prices of these stocks.

Valuing a cyclical stock:

Cyclical businesses tend to have low valuations and are often available at a cheaper prices due to their unpredictable earnings flow. So, it's important not to compare the valuation of a cheap cyclical stock to that of an expensive secular growth story. Investors should consider buying cyclical stocks when they are performing poorly and selling them when they are doing well - the only caveat being the company should not be heading towards bankruptcy. The business environment for these stocks can shift quickly, making it challenging for investors to forecast long-term outcomes. As a result, short-term and medium-term buyers may be rewarded, while long-term holders may experience sleepless nights, which is not the norm for the stock market, where long-term buyers are typically rewarded over short-term buyers. 

The cyclical stocks are primarily valued based on the prices of their underlying commodities. Investors interested in buying or selling cyclical stocks should pay attention to the fluctuations in commodity prices. However, when analyzing cyclical stocks based on cash flow or evaluating them based on dividend yields, it is challenging to project future earnings with accuracy. As a result, assigning a forward P/E to cyclical stocks is not possible. 

It's fascinating to note that while the P/E ratios of secular growth stocks tend to increase during good times and decrease during bad times, cyclical stocks follow an opposite trend. During prosperous periods, the P/E ratios of cyclical stocks contract, but during tough times, the ratios expand. But why does this happen? 

Typically, when commodity prices decline, companies that produce those commodities tend to incur losses, leading to a decrease in Earning Per Share (EPS) and an increase in the Price to Earning (P/E ratio). Conversely, when commodity prices rise, these companies report significant profits, causing a drop in the P/E ratio, which is due to the sharp rise in the denominator, i.e., earnings of a cyclical stock.  

So, what's the key takeaway? To quote Peter Lynch again, "Cyclicals are like blackjack: stay in the game too long, and it's bound to take back all your profit." The key to investing in cyclical stocks is to approach them with caution, avoid assuming that they are forever like secular growth stocks, and carefully monitor their performance. So, buckle up, because investing in cyclical stocks is not for the faint of heart, but for those who dare to ride the thrilling ups and downs, the rewards can be worth it.

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