Cyclical stocks: what are they and why you should care

Why invest in cyclical stocks?

Investing in cyclical stocks can offer significant opportunities, but it's essential to understand why and when they might be the right choice for your portfolio.

Here are the six reasons to consider investing in them:

1. Potential for high returns

Cyclical stocks tend to outperform during periods of economic expansion. As the economy grows, consumer spending increases, driving up the revenues and profits of companies in cyclical industries.

This can – potentially – lead to substantial gains in the stock prices of these companies. For investors who can time the market effectively, cyclical stocks offer the potential for high returns, particularly during the early stages of an economic recovery.

2. Diversification benefits

Cyclical stocks typically behave differently from non-cyclical (defensive) stocks, which tend to remain stable regardless of the economic environment.

By diversifying your investments, you can reduce overall portfolio risk and potentially smooth out returns across different market conditions.

3. Opportunities during economic recoveries

Cyclical stocks are often most attractive at the start of an economic recovery. When the economy begins to rebound after a downturn, cyclical stocks are usually among the first to benefit from increased consumer spending and business investment.

Investors who buy cyclical stocks during these periods can benefit from the market's early gains, potentially reaping significant rewards as the recovery continues.

4. Sector-specific advantages

Different cyclical sectors may outperform at various stages of the economic cycle. For example:

• Consumer cyclical stocks may benefit early in a recovery as consumer confidence returns.
• Industrial cyclical stocks might gain momentum later in the cycle when infrastructure spending increases.
• Technology cyclical stocks could see a boost as businesses ramp up investment in new technologies during growth phases.

5. Hedging against inflation

Cyclical stocks, particularly those in sectors like commodities and energy, can serve as a hedge against inflation. When prices for goods and services rise, companies in these industries often benefit from increased revenues, which can translate into higher stock prices.

Investing in these types of cyclical stocks can provide a buffer against the effects of inflation on your overall portfolio.

6. Long-term growth potential

Cyclical stocks can be a valuable addition to a diversified portfolio for investors with a long-term horizon. While they may experience volatility, the overall upward trend of the economy over time means that well-chosen cyclical stocks can have significant long-term growth.

Investors who are patient and can tolerate short-term fluctuations may find cyclical stocks to be a rewarding component of their investment strategy.

Timing and risk management considerations:

It's important to note that the timing of investments in cyclical stocks is an important factor. Buying too late in the economic cycle can expose you to the risk of a downturn, while buying too early can make you wait a long time for returns. As a result, being up to date about economic indicators and market trends is essential.

Additionally, due to their inherent volatility, cyclical stocks are often better suited to investors who are comfortable with taking on higher levels of risk. Proper risk management strategies, such as setting stop-loss orders and maintaining a diversified portfolio, are critical to mitigating potential losses. Remember, problems in an individual company, such as indebtedness or poor business performance, can lead to them lagging the overall market regardless of the business cycle.

Cyclical vs. non-cyclical stocks

It's important to distinguish between cyclical and non-cyclical stocks, as they respond differently to economic conditions.

Non-cyclical stocks, also referred to as defensive stocks, are shares in companies that provide essential goods and services that people continue to buy regardless of the economic situation. These include utilities, food, and healthcare products—things that remain in demand no matter what the economy is doing.

Examples of non-cyclical stocks include:

• Utilities. Companies like National Grid (UK) and Enel (Italy) provide essential services like electricity and water that people can't do without, even in tough times.
• Consumer staples. Firms like Nestlé and Unilever, which produce everyday items such as food and household products, maintain steady demand as consumers continue to purchase these necessities.

Non-cyclical stocks are typically less volatile than cyclical stocks, making them a stable choice for more conservative investors. They offer protection during economic downturns because their performance doesn't fluctuate as much with the economy's ups and downs. Some non-cyclical stocks are regular dividend payers. However, they may not experience the same level of rapid growth during economic booms as cyclical stocks do.

Combining cyclical and non-cyclical stocks

A balanced portfolio often includes both cyclical and non-cyclical stocks. This mix lets you capture growth during economic expansions through cyclical stocks, while non-cyclical stocks provide stability during downturns. This diversification allows you to build a portfolio that is more resilient to changes in the economic environment.

For example, while your cyclical stocks might drive gains when the economy grows, your non-cyclical stocks can help cushion your portfolio during recessions or slowdowns.

Conclusion: The value of cyclical stocks in your portfolio

Cyclical stocks offer solid growth potential, especially during economic booms. Since their performance is closely linked to the economy, they're a great option if you're looking to take advantage of market upswings. But with that potential comes volatility, so careful timing and consideration are crucial.

Adding cyclical stocks to your strategy can help you benefit when the economy is on the rise. While non-cyclical stocks bring stability, cyclical stocks can deliver higher returns when times are good. The important factor is understanding where we are in the economic cycle, and adjusting your portfolio accordingly.

For investors willing to accept a bit more risk in exchange for greater rewards, cyclical stocks can be an essential part of a well-rounded investment strategy.