Understanding and positioning a portfolio for cyclical, non-cyclical and counter-cyclical stocks is perhaps one of the most neglected parts of investing. Broadly, the thinking here is that the profitability of cyclical stocks is very much aligned with the general economy – counter-cyclical stocks do better in tough economic t i mes, while non- cyclical stocks pretty much make profit regardless.
A ‘ buy and hold’ investment strategy should really only focus on the noncyclical stocks. Those that make money regardless of what the economy is doing – sure, in tough times profits may weaken but importantly they still make a profit. Examples of these would be food retailers, health, education and to a degree sin stocks (beer and cigarettes). Regardless of how the economy is doing or how we’re doing at an individual level we have to eat, look after our health, educate our children and if we can, squeeze in a drink or three to help cope with the tough times. In some instances these would be considered defensive stocks in that they survive the tough times much better than most businesses. These stocks fit perfectly into a straight ‘ buy and hold’ strategy, the price may weaken at times but the longer term trend is upward for the strong ones.
With cyclical stocks, we need to time our buying and selling, trying to get in around the bottom of the price moves and exiting around the top. Two examples of sectors in this space are mining and construction; they boom when the economy booms but they seriously struggle when the economy struggles. Small-cap stocks will often also be cyclical as they are typically very closely tied to the country’s economy as they tend to only really operate within one country (in our case this would be South Africa).
The problem with cyclical stocks is the timing. Buying a non-cyclical is easy – when it is cheap, jump on board and pretty much hold it for as long as that company is the dominant player in its space. Cyclical is a whole lot harder, as timing the bottom is practically impossible. So the best case here is that you buy too early and prices go nowhere for a couple of years as you wait for the recovery. The worst-case scenario is that you buy while it’s still falling and by the time the stock reaches bottom you’re already markedly under water. The other problem with cyclical is the selling – you have to sell when the stocks are booming and again. We seldom time that right. Either we sell far too early or we are unable to sell at the top (because of all the good news f lowing) and so we miss the exit and find ourselves holding when the stocks are halfway down again.
For me personally it is simple – non-cyclical stocks are for long-term investment portfolios, the classic ‘ buy and hold’. Cyclical stocks are more for a trading portfolio and sure, the position may be held for many years and the entry and exit is much harder, and, as such, I have very little exposure to cyclical stocks in my portfolios.
Counter-cyclical are those that do well in tough economic times and less so when the economy is strong. The obvious one here would be debt collection. During tough times more people default on loans so the debt collection companies see increased business. The benefit for the shareholder is that while much of a portfolio may be struggling during the tough times, these counter-cyclical stocks will be doing great. The trick here is finding these counter-cyclical industries and they are very few and no listed companies spring to mind as being counter-cyclical.
Simon Brown is a Finweek contributor and heads justonelap.com, a free resource of financial information and investment education.