Cyclical Industry
An industry whose performance is strongly correlated to business cycle
What is a Cyclical Industry?
Cyclical industry refers to an industry whose performance patterns are strongly correlated and affected by the business cycle. When the economy is growing or expanding, these companies grow, and when the economy is in a recession or depression, they decline.
An industry classified as cyclical is sensitive to the business cycle, which results in higher revenues during periods of economic expansion, but lower revenues during periods of economic contraction and downturn.
Employers in these industries can pay bonuses, hire en masse during good times, and lay off or cut employees in bad times to cope with this type of volatility.
Key Takeaways
- Cyclical industries are sensitive to economic cycles, with revenues rising during expansions and falling during recessions.
- Key indicators for evaluating cyclicality include the Purchasing Managers Index, the Index of Industrial Production, and the Consumer Price Index.
- The four phases of a business cycle are expansion, peak, contraction, and trough. Understanding these phases helps determine industry performance.
- Cyclical stock values fluctuate with the state of the economy, driven by factors like beta, EPS, and PE ratio.
- Examples of cyclical industries include basic materials, financial services, consumer discretionary, real estate, communication services, energy, technology, and industrials.
Cyclical industries business model
Businesses in this category carefully plan for seasonal changes to withstand economic fluctuations. For example, a cyclical industry generally reduces the number of employees, purchases fewer supplies and materials, and makes a smaller capital investment during recessions.
Additionally, these businesses reduce production levels to compensate for lower demand and reduced purchasing power. By implementing these changes, cyclical companies can remain sustainable despite the drastic changes in the economy.
During the economic growth period, these companies increase purchasing and production levels and hire new employees. In addition, they may raise salaries or pay special bonuses to attract top employees in the industry and encourage increased production.
Cyclical Industry Indicators and Factors
Cycle-sensitive industries are often affected by business cycles, so during downturns in an economic cycle, consumers prioritize expenses and reduce unnecessary costs.
The most vulnerable industries to economic contraction are those specializing in nonessential products.
Despite this, energy and utility industries tend to weather economic storms much better because people will always find a way to pay their bills regardless of what's going on in the economy.
Indicators
This industry can be evaluated using three important indicators. These are
1. Purchasing Managers Index
The Purchasing Managers Index is a monthly study conducted by privately owned companies or exchange associations amongst the acquiring supervisors of privately owned companies within a particular nation.
This review aims to quickly determine whether or not there has been an improvement in business movement. In this way, we can distinguish the cycles of the monetary system and, accordingly, help the investor in his decision.
2. Index of Industrial Production
A single index that serves as a measure of the growth rates in various sectors of the economy over a period. It will help guide the investor in assessing the performance of stocks industry-wise to make a well-informed investment decision.
3. Consumer Price Index
This indicator measures the price of goods and services, thus allowing investors to identify the economic state in which they are currently operating, such as inflation, deflation, or stagflation.
Factors
The factors affecting are:
a) Total National Output (GDP)
The economic performance of cyclical businesses is legitimately influenced by gross domestic product (GDP), an estimation of monetary yield.
GDP growth suggests that the economy is expanding, prompting higher employment and, thus, more disposable income, resulting in individuals spending more on various things.
In addition, it demonstrates an increment in government spending by the foundation and by unified activities.
b) Shopper Spending Levels
This affects repeat business and stock levels. In addition, the Consumer Confidence Index (COI) can provide insight into how much individuals are saving compared to how much they are spending and the overall feeling of the market.
Using this Index, one can gauge the degree to which purchasers are idealistic or cynical about the economy's prospects.
If the supply of products and services is high, one can rely on purchasers to increase their spending on products and services. On the other hand, spending will likely decline if the supply of goods and services is low.
According to this reasoning, the repeating enterprises head southward with their loads. And the organizations like Tata Motors, Omega, LG, and the hospitality industries are usually flooded with customers when the economic environment is good.
c) Interest Rates
As the key indicator of economic stability in any country, interest rates are the leading indicator of that country's economic health.
Since these rates are used as a benchmark for lending and borrowing, cyclical stocks are highly affected by the changes in these rates.
A higher interest rate indicates that the economy is expanding and consumers have high purchasing power. Therefore, the central bank keeps the rate high to control consumers' spending.
A low rate indicates that the government is trying to inject liquidity into the market to spur economic growth.
d) Inflation
One of the primary indicators of a healthy economy is inflation. This indicates a rise in the price of a wide range of goods and services over a while.
For example, in 2009, a McDonald's burger cost $2. However, the cost of the same burger in 2019 was $6. This is because the currency's value has risen because of inflation.
Higher inflation hurts the economy, which is why cyclical stocks tend to dip, whereas low inflation is a positive sign for cyclical stocks.
Understanding the Business Cycle
A business cycle can be divided into four discrete phases. Therefore, it is important to understand the business cycle to determine how industries function.
Though business cycles can last for different lengths of time, they are generally characterized by the same standard pattern. The four stages of a business cycle are
1. Expansionary Phase
The expansion phase is the beginning of a business cycle. This is the time when the economy grows. A period of expansion is marked by rising productivity, declining unemployment, and rising stock market values.
In this phase, more people are employed with growth in their investment portfolios. As a result, they have more discretionary income and are less reluctant to spend.
The tendency of consumers to invest more causes the stock market to expand.
2. Peak Phase
During the expansionary phase, the economy reaches its peak. After this point, the expansionary phase ends, and a contraction phase begins.
As the expansion stage reaches its peak, economic growth stops and both the unemployment rate and the price of goods reach record highs.
This indicates that the economy has become saturated and can no longer support growth. Consequently, the economy will begin to decline as this phase ends.
3. Contraction Phase
During economic contractions, discretionary income tends to decline due to the loss of jobs and productivity.
As the economy begins to contract, several warning signs emerge. There is a decline in production and demand, an increase in unemployment, and a decrease in wages.
An economy enters a depression when GDP drops below its starting point at the beginning of the business cycle.
During contractions, recessions may occur, though not all contractions lead to recessions. The most common indicator of an economic recession in the United States is a decline in GDP for two consecutive quarters.
4. The Trough
There is a trough phase at the end of the business cycle. This phase is characterized by negative economic growth. During this phase, supply, demand, and unemployment indicators reach their lowest levels.
It is at the end of the trough stage that a new business cycle is initiated, and consequently, the economy enters a recovery stage.
Performance Drivers of Cyclical Stocks
Throughout a business cycle, the value of a publicly traded company can fluctuate significantly. Similar to cyclical industries, cyclical stock values are directly linked to the state of the economy.
Businesses lose revenue when economic growth slows, and consumers stop buying their products and services. Stock prices fall as a result. In the event of a prolonged contraction or depression, these cyclical companies may cease operations.
The value of cyclical stocks typically rises during expansion and peak stages. Corporate revenue and stock value increase with demand and production.
Buying and selling cyclical stocks can be lucrative, but it's not always easy to predict how they will perform. Economic trends can be slow to appear, and even experienced investors may struggle to predict them accurately.
Consequently, cyclical stocks may be less suitable for inexperienced investors or those with restricted portfolios due to their cyclical nature.
Aspects that drive cyclical stock performance and price are listed below:
a) Beta of Stock
First, there is the Beta coefficient or systematic risk. The beta coefficient is a statistical measure of a stock's sensitivity to the market. In general, cyclical has a high beta, which is greater than 1.
For example, a beta of 2 indicates that if the market falls by 10%, the stock will probably fall by 20%.
In contrast, non-cyclical stocks have a low beta, which means that these stocks are less affected by the rise or fall of the market compared to cyclical stocks.
b) Earnings Per Share (EPS)
EPS is the income an organization makes from its operations after all expenses are paid. EPS is inextricably connected to the revenue an organization generates. The higher your income, the more you can expect your earnings per share to be.
EPS for cyclical stocks are typically very volatile, much more than non-cyclical stocks since their earnings are very sensitive to the sentiment in the economy.
c) Price-Earnings Ratio (PE Ratio)
One of the most widely used metrics by traders and investors in the market is the PE ratio. It considers the price of a stock with the EPS (Price to Earnings).
The stock price of 12 implies that the financial investor is paying multiple times of EPS to purchase the stock (with the expectation that the EPS will remain the same). The ratio between EPS and price generally determines a stock's price.
The historical data suggests that cyclical stocks tend to have a lower PE than non-cyclical stocks. However, as non-cyclical stocks offer greater protection against the economic downturn, they command a higher price.
Classification of Cyclical Industry
The industry can be classified as
1. Consumer Purchasing Behaviors
Without diving into a company's financial statements, understanding consumer purchasing behavior is a critical starting point in determining whether an industry is cyclical.
The industry will likely be cyclical if consumers limit their purchases during an economic downturn.
The airline industry is a classic example. During economic downturns (when disposable income is lower), consumers tend to be more conservative and cautious about airfare spending.
In contrast, pharmaceuticals are a non-cyclical industry since they demand them (as an essential good) regardless of economic growth or contraction.
2. Financial Statements
Financial statements provide information about an organization's business activities and financial performance.
Financial statements are frequently audited by government agencies, accountants, and firms for tax, financing, or investing purposes.
A financial statement includes
To evaluate an industry's cyclicality, analysts examine companies' financial statements and analyze their top-line revenue streams.
In general, industries with high volatility in their revenues have a greater likelihood of being cyclical than those with a lower level of volatility.
3. Performance
During economic downturns, cyclical industries tend to perform poorly since they are sensitive to fluctuations in supply and demand.
The primary reason for the decrease in consumer spending is the decline in disposable income, as consumers become more hesitant to spend.
Businesses that operate in cyclical industries suffer a significant decline in the value of their real estate more than those that operate in non-cyclical markets.
In addition, it is important to note that this does not mean that non-cyclical industries experience strong performance during economic downturns. However, the performance of non-cyclical industries is often less negatively impacted in economic downturns.
It is reasonable to conclude that during the 2008 Global Financial Crisis, US companies operating in non-cyclical industries suffered relatively less than cyclical ones.
Cyclical Industry Examples
Generally, industries that manufacture durable goods, such as raw materials and heavy equipment, are cyclical.
In addition, consumer discretionary goods (goods and services that consumers buy with discretionary income) are highly sensitive to business cycles because they are easier to cut from a consumer's budget during hard times than essential items.
For example, when the economy is doing well in Aviation, people have more disposable income, so they will take more vacations and travel by air more frequently.
In contrast, people are much more cautious about spending during difficult economic times. As a result, they tend to spend less on vacations and avoid expensive air travel.
Some of them are:
a) Basic Materials
Due to their dependence on construction and industrial expansion, companies in these sectors tend to be cyclical. Examples include Freeport-McMoRan and Rio Tinto, which supply commodity metals.
The other examples include chemical companies such as Sherwin-Williams, Air Products and Chemicals, Dow Inc., and DuPont de Nemours & Company.
b) Financial Services
It is cyclical since it is intrinsically linked to increased expansion, investment, and liquidity. Payment processors and credit cards such as Visa, Mastercard, American Express, and Discover are good examples.
Other examples are banking institutions such as JPMorgan Chase, Bank of America, Wells Fargo, and Morgan Stanley.
c) Consumer
For obvious reasons, this type of business is very cyclical; when consumers have more money, they spend more on products and services.
A good example is when retailers can increase sales revenues for companies like Amazon, Home Depot, Alibaba, and TJX Companies ("TJ Maxx").
Other examples include consumers purchasing vehicles from automakers such as Ford, Toyota, and Tesla.
d) Real Estate
Here, consumers tend to improve or buy homes during ng economic boom and rising incomes.
The most common examples of real estate investment trusts (REITs) are Prologis, American Tower, Simon Property Group, and Digital Realty Trust.
Other examples include increased revenues for real estate services firms such as CBRE Group, CoStar Group, and KE Holdings.
e) Communication Services
Communication services are sensitive to cyclical fluctuations because they depend on business investments, such as marketing, and include basic communication necessities, such as cellular phones.
In this context, Internet content companies, including Google (now "Alphabet"), Facebook (now "Meta Platforms"), and Twitter, are good examples. Other examples include AT&T, Verizon, T-Mobile, and other services.
f) Energy
It is interesting to note that energy is also cyclically sensitive, as demand is generally higher during good times. However, it can also be cyclically sensitive depending on supply, which is not directly connected to the economy.
Exxon Mobil, Chevron, and Shell are examples of oil & gas majors that fall into this category.
Midstream companies such as Enbridge, Enterprise Products Partners, and TC Energy also fall into this category.
g) Technology
Technology companies tend to suffer from cyclical fluctuations because some provide essential business services, whereas others are more closely tied to discretionary consumer spending.
Software companies like Microsoft, Adobe, and Salesforce.com are examples of this phenomenon. Some indirect examples include semiconductor companies such as NVIDIA, ASML Holding, and Broadcom.
h) Industrials
These industries are cyclically sensitive since some rely on economic growth, and others provide the basis for our everyday lives. The list includes companies such as UPS, Union Pacific, and FedEx, which provide freight and logistics services.
Other examples include aerospace and defense companies like Raytheon, Lockheed Martin, and Northrop Grumman.
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