The stock market is always forward looking, and market participants move to price in expected profits or macroeconomic forecasts well before those shifts are reflected in reality. To invest in cyclical stocks, investors should know when to enter the market.
In simple language, cyclical stocks are those whose fortunes swing as per the business cycle in an economy. These companies have a direct relationship with economic growth. Revenues and profits of these companies grow or degrow in tandem with the state of the economy as their performance is tied to the business cycle. Cyclical companies follow the trends in the overall economy, from expansion, peak and recession all the way to recovery.
The stock market does not move with the economic cycle; it moves in anticipation of an economic cycle, or at least tries to. That means the market cycle is usually well ahead of the economic cycle. Investors have no control on the cycles of the economy, but can tailor their investing practices to its ebbs and flows of the economic cycle. Here, one should understand that there are fundamental differences between companies that are affected by broader economic changes and those that are virtually immune to them.
Implementing the right strategy requires a good knowledge of the economy and how the market works. Otherwise it becomes incredibly difficult to make investment decisions.
However, a good investment strategy might be to buy cyclical stocks at the start of an economic expansion and sell them just before a slowdown begins in the economy. Before selecting a cyclical stock, it makes sense to pick an industry that is due for revival. In that industry, choose companies that look especially attractive. The biggest companies are often the safest. Smaller companies carry more risks, but they can also produce impressive returns.
However, for investors, whether a turnaround happens fast or not, it is always better to stick with quality names, even in the cyclical sectors. Healthcare, consumer staples and basic transportation are examples of relatively inelastic industries that can perform well even during tough times. In a sectoral rotation, sectors like transportation, technology, services stocks move first followed by capital goods and energy, among others. To identify a trend; investors should look for signals like an increase in interest rates or decrease in consumer spending, among others.
Given the ups and downs of the economy, and, consequently, that of cyclical stocks, successful cyclical investing requires careful timing. However, it is always a smart idea to own a combination of both cyclical and defensive stocks in a portfolio. By doing so, investors can prosper when the economy is growing, and cushion the downside when the economy turns weak. However, it is important to study the market carefully and have a good risk tolerance.
(DK Aggarwal is the CMD of SMC Investment and Advisors)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)