Cyclical Stocks are those company’s whose line of business means that their fortunes will to a large extent depend on the ups and downs of the economy. As the economy strengthens, theses firms will see higher returns and vice versa when the economy declines. They tend to experience higher price volatility in exchange for these higher expected returns.
Examples might include those that concentrate on items that require consumer expenditure to increase, such as travel, car manufacturers or construction firms.
Trading Cyclical Stocks
Cyclical stocks generally produce products that are deemed non-essential (or discretionary). When the economy slows down and people expect job losses or pay cuts, they may be less likely to spend money on designer goods for example.
Non-cyclical stocks (e.g. food producers and retailers) tend to have more stable sources of profits and are generally seen as defensive investments but they do not significantly benefit from economic expansions.
One of the best ways to identify a cyclical stock is to look at its Beta coefficient to the market. This measures how volatile the share price is relative to an Index (e.g. the FTSE 100).
A beta of 1 indicates that it tends to move in line with the broader market.
Cyclical shares tend to have Betas in excess of 1.25, which implies that it will move 1.25x the extent of that of the underlying Index (either up or down). Non-cyclical firms tend to have Betas below 1.
The higher the Beta, the more important it is to time the purchase and sales of the share correctly and this is where the problems can arise.
In order to do so, one must know with reasonable precision where one is in the economic cycle.
Valuation measures such as Price/Earnings ratios can be misleading in this regard, as low P/Es often occur when earnings (the denominator in the measure) are at their best and at their highest at the depths of recessions (when earnings have been pummelled).
So, care is needed, though an efficient diversification process can mitigate these risks somewhat.
Some firms can change their categorisation over time; telecom shares for example have gone from being very economically sensitive issues to being more utility-like; consumers have shown themselves reluctant to dispense with their mobile phones and subscriptions to Sky Sports, Netflix etc allowing companies like SKY and BT for example to show much more stability of income.
As a result, their market Betas have shown a declining trend over the last few years.