Investing in Cyclical Stocks

Some stocks are quite vulnerable to recessions and economic slowdowns, while others are well-positioned to generate profits in any economic climate, making them relatively recession-proof. That the economy experiences periods of boom and bust is the basic idea underlying the concept of cyclicality.

We've seen cyclicality play out firsthand in many areas of the stock market during the COVID-19 pandemic. Economically sensitive stocks initially declined as the economy contracted. Most companies' stocks subsequently rebounded as the economy began to recover, thanks in part to government stimulus programs and low interest rates.

Here’s what you should know about investing in cyclical stocks.

What is a cyclical stock?

A cyclical stock is one whose underlying business generally follows the economic cycle of expansion and recession. Cyclical businesses perform well during economic expansions but typically experience significantly declining sales and profits during recessions and other challenging economic times.

Best cyclical stocks to buy in 2021

With the economy reopening alongside the vaccine rollout, cyclical stocks should thrive in 2021. Here are three cyclical stock picks for the post-pandemic era:

1. The Walt Disney Company

Disney (NYSE:DIS) has done quite well during the pandemic, thanks to Disney+, which benefited from people being stuck in their homes. However, many of the company’s parks and experiences had to close or significantly reduce their capacity because of the pandemic. Likewise, most theaters closed, which hurt Disney's studio business.

Disney’s experiential businesses can now completely reopen and should benefit from significant pent-up demand from people who stayed at home for most of the past year. Disney’s earnings are likely to increase, which should drive its stock price higher.

2. Expedia

Expedia (NASDAQ:EXPE) operates several travel websites. The pandemic has had a significant impact on travel due to government-mandated travel restrictions, and, as a result, fewer people booked trips using Expedia’s websites.

However, with restrictions lifting, people are starting to travel again. Because of that, Expedia should benefit from a surge of bookings on its websites. That should boost its income and its stock price.

3. EPR Properties

EPR Properties (NYSE:EPR) is a REIT focused on owning experiential real estate such as movie theaters, ski resorts, eat and play locations, and other attractions. Many of its tenants struggled during the pandemic due to government-mandated shutdowns of non-essential businesses and frequently weren’t able to pay rent. EPR Properties was forced to suspend its dividend during the pandemic.

However, the company worked with tenants on deferring rent until market conditions improved, and now that the economy is reopening, its tenants, like Disney, should benefit from pent-up demand for entertainment. That should enable them to catch up on their rent, which should benefit EPR and its shareholders.

Examples of cyclical industries

It’s not practical to list every cyclical industry, but to give you a good idea of some of the sectors prone to cyclicality, here are eight prominent and easy-to-understand examples:

• Airlines: During strong economies, both individuals and businesses tend to be more willing and able to spend money on airline tickets than during lean times.
• Hotels: Like airlines, hotels depend on individuals and businesses spending money on travel.
• Retail: During times of economic contraction, people tend to spend less on discretionary retail goods. However, retailers primarily selling things that people need are not typically as cyclical, especially when they prioritize offering discounts. In fact, Walmart (NYSE:WMT) stock can be considered countercyclical since the company often increases its sales during tough times.
• Restaurants: In poor economies, people eat at home more often than they do during prosperous times, and restaurant stocks often suffer as a result.
• Automakers: Consumers tend to hang on to their vehicles longer when recessions hit and are more inclined to buy new vehicles in prosperous times, so automaker stocks tend to be quite cyclical.
• Technology: Most (but not all) tech stocks are cyclical. Individuals and businesses are less inclined to spend money on the latest technologies and electronic devices during recessions.
• Banks: In a recession, the profitability of banks often declines. Recessions reduce demand for banking products, including mortgages, auto loans, and credit cards, and more consumers who already have loans struggle to pay their debts. In addition, interest rates tend to fall before and during recessions, causing bank profit margins to contract.
• Manufacturing: In tough times, as individuals and businesses spend less on pretty much everything, companies that manufacture physical products tend to experience plunging demand.

Many of the sectors mentioned above, such as automotive and retail, are consumer-facing industries and therefore part of the consumer cyclicals sector. Consumer cyclicals are consumer discretionary goods that, unlike consumer staples, aren’t strictly necessary purchases.

Consumer cyclicals are divided into two subcategories: durable and non-durable. Durable cyclicals include physical consumer goods that have long useful lives (e.g., vehicles). Non-durable cyclicals have shorter useful lives or are consumed quickly (e.g., clothing and prepared foods).

Each recession and economic downturn is usually different. In the COVID-19 pandemic, many of the industries mentioned above -- banking and retail, for example -- have been negatively impacted. With the pandemic forcing people to stay at home, technology stocks have performed incredibly well, and many tech companies have either been largely unaffected or actually benefited from the circumstances.

Examples of non-cyclical industries

Some types of businesses aren’t affected much by economic cycles. The stocks of these companies are non-cyclical and known as defensive stocks or recession-proof because they tend to perform similarly during both economic contractions and expansions

Here are a few of the most prominent non-cyclical industries:

• Non-discretionary retail are companies selling things that people need, and they tend to be rather resilient in nature. In addition to big-box retailers like Walmart, drugstores and grocery stores fit into this category.
• Utilities stocks tend to be highly defensive since consumers (for the most part) continue to pay their electric and water bills even during the deepest recessions.
• Real estate is another sector that is considered defensive, although the degree of defensiveness of a stock depends on the nature of the company’s properties. Real estate investment trusts (REITs), for example, that focus on office properties or hospitals usually perform better in difficult economies than owners of hotels.

That said, the nature of a recession or downturn can have surprising effects on normally defensive holdings. Many types of REITs rely on businesses being open, so real estate stocks that might otherwise have been considered defensive have generally underperformed during the COVID-19 pandemic

Examples of cyclical and defensive stocks

To give you some concrete ideas of the types of stocks we’re talking about, here are some common cyclical and defensive stocks:

Cyclical Stocks

• JPMorgan Chase (NYSE:JPM)
• Apple (NASDAQ:AAPL)
• General Motors (NYSE:GM)
• Boeing (NYSE:BA)
• Texas Roadhouse (NASDAQ:TXRH)

Defensive Stocks

• Dominion Energy (NYSE:D)
• Costco (NASDAQ:COST)
• Equity Residential (NYSE:EQR)
• General Mills (NYSE:GIS)
• Coca-Cola (NYSE:KO)

To be clear, none of the companies on these lists are perfectly cyclical or perfectly defensive. Depending on the circumstances of a specific recession, some of the cyclical names could do relatively well, while the defensive stocks could see profits decline significantly. However, these are still good examples of stocks that generally behave either cyclically or defensively.

When should you buy cyclical stocks?

In a perfect world, a viable investment strategy would be to buy cyclical stocks at the start of an economic expansion and then sell them just before a recession begins. But trying to predict the timing of a future recession or expansion is a losing battle.

It's smarter to own a combination of both cyclical and defensive stocks in your portfolio. That way, you are well-positioned to prosper when the economy is growing but also have some downside protection when the economy contracts.