How Cyclical Stocks Respond to Economic Changes
Cyclical stocks benefit when the economy expands, as that drives growing demand for their products and services. That enables them to expand their operations to capture this growth, boosting their earnings and stock prices and increasing their ability to return cash to investors via dividends and share repurchases.
However, when the economy slows, demand for economically sensitive products and services also slows. That impacts their financial results, leading to a decline in their stock prices. Cyclical companies often respond to these changes by reducing their workforce, cutting capital spending, and, in some cases, reducing the amount of cash they return to shareholders.
Benefits and risks of investing in cyclical stocks
Cyclical stocks have their pros and cons. Some of the advantages of investing in cyclical stocks include:
- Benefiting from economic growth: Cyclical companies tend to see increased demand for their products and services as the economy expands.
- Potential inflationary hedge: Cyclical companies can help you hedge your portfolio against inflation when consumer spending is rising.
- Income: Many cyclical stocks pay dividends, which can be higher during periods of economic growth.
Meanwhile, some of the risks of investing in cyclical stocks include:
- Variable earnings: The profitability of cyclical companies tends to ebb and flow with the economic cycle.
- Dividend cuts: Cyclical companies are more likely to cut dividends during an economic downturn.
- Financial issues: A severe economic downturn can cause significant financial problems for some cyclical companies.
What to look for in a cyclical stock
Investors should look for a few things when investing in a cyclical stock:
- Balance sheet strength: The company should maintain a strong investment-grade balance sheet with low leverage relative to peers. This will enable a cyclical company to rely on its balance sheet to navigate through the low point of the economic cycle.
- Durable competitive advantages: Look for a company that has notable competitive advantages over rivals, such as brand power, low-cost operations, and strong customer relationships. It can use its competitive advantages to take market share during an economic downturn.
- Secular growth drivers: Look for a company capitalizing on a longer-term growth trend that should remain strong during a recession.
When should you buy cyclical stocks?
In theory, the ideal strategy is to buy cyclical stocks at the start of an expansion and sell just before a recession. In practice, no one can reliably predict that timing.
A more practical approach is to hold a blend of cyclical and defensive stocks. That way, you're positioned to benefit when the economy grows, while your defensive holdings provide some cushion when it contracts.
