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To be a successful investor, you need specific skills. But if you don't understand how the global economy works and how the market behaves, it will be hard to make the right choices.
Now, every economy goes through ups and downs, like a cycle. It's called a business cycle. And even though we can't control the market, we can adapt ourselves and our decisions to the changing conditions. It's important to know that depending on this business cycle, there are two types of companies. The first type, called cyclical companies, have stock values closely tied to changes in the business cycle.
On the other hand, we have non-cyclical companies, which are more resistant to market fluctuations. In this article, we'll explore these two types of companies in more detail. Let's get started on this journey!
What Is A Cyclical Stock?
A cyclical stock refers to the stock of a company that is highly influenced by changes in the business cycle. These companies are typically engaged in industries that are sensitive to economic conditions, such as consumer discretionary goods (e.g., automobiles, luxury items), construction, travel, and manufacturing.
When the economy is doing well and experiencing expansion, cyclical companies tend to perform strongly. Increased consumer spending and business investment during these times boost their revenue and profitability. As a result, the stock prices of cyclical companies generally rise.
However, during economic downturns or periods of contraction, cyclical stocks can be more vulnerable. Reduced consumer spending and business investment can lead to lower demand for their products or services, causing their revenue and profits to decline. Consequently, the stock prices of cyclical companies may decrease.
Sectors Of Cyclical Stocks
Here are some common examples of cyclical sectors and stocks and an explanation of why they are considered cyclical:
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Automotive
The automotive sector is cyclical because it is highly sensitive to economic conditions and consumer discretionary spending. During economic expansions, demand for cars and related products increases, leading to higher sales and profitability for automotive companies. For example:
- General Motors Company (GM)
- Ford Motor Company (F)
- Toyota Motor Corporation (TM)
- Volkswagen AG (VWAGY)
- Tesla, Inc. (TSLA)
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Travel and Leisure
The travel and leisure sector is cyclical as it depends on consumers' ability and willingness to spend on travel, vacations, and leisure activities. Economic downturns and uncertain times can lead to reduced travel and discretionary spending, negatively impacting companies in this sector. For example:
- Carnival Corporation & plc (CCL)
- Delta Air Lines, Inc. (DAL)
- Hilton Worldwide Holdings Inc. (HLT)
- Marriott International, Inc. (MAR)
- Expedia Group, Inc. (EXPE)
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Consumer Discretionary
The consumer discretionary sector is cyclical because it relies on consumer spending patterns, which tend to fluctuate based on economic conditions. During periods of economic strength, consumers have higher disposable income and are more likely to spend on non-essential goods and services. For example:
- Amazon.com, Inc. (AMZN)
- Nike, Inc. (NKE)
- Starbucks Corporation (SBUX)
- Home Depot, Inc. (HD)
What Is A Non-Cyclical Stock?
A non-cyclical stock, also known as a defensive or non-cyclical company, refers to the stock of a company that is less influenced by changes in the business cycle. These companies operate in industries that provide essential goods or services that people need regardless of the state of the economy.
Non-cyclical companies are often found in sectors such as utilities, healthcare, consumer staples (e.g., food, beverages, household products), and basic services (e.g., telecommunications). These industries tend to have stable demand regardless of economic conditions because the products or services they offer are considered necessities.
During periods of economic expansion, non-cyclical stocks may not experience the same level of growth as cyclical stocks, as their demand is generally consistent. However, they provide investors with a sense of stability and reliability. When the economy faces downturns or recessions, non-cyclical stocks tend to be more resilient. People still require utilities, healthcare, and essential goods regardless of their financial situation, which can help support the revenue and profitability of non-cyclical companies.
Non Cyclical Stocks Sectors
Here are some common examples of non-cyclical sectors and stocks and an explanation of why they are considered non cyclical:
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Utilities
Utilities are considered non-cyclical because people continue to consume electricity, water, and gas regardless of the economic conditions. The demand for essential utilities services remains relatively stable, making these companies less sensitive to changes in the business cycle. For example:
- NextEra Energy, Inc. (NEE)
- Duke Energy Corporation (DUK)
- Dominion Energy, Inc. (D)
- American Electric Power Company, Inc. (AEP)
- Southern Company (SO)
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Healthcare
Healthcare is a non-cyclical sector as demand for healthcare products and services remains constant regardless of economic fluctuations. People require medical treatments, medications, and healthcare services regardless of the state of the economy. For example:
- Johnson & Johnson (JNJ)
- Pfizer Inc. (PFE)
- Merck & Co., Inc. (MRK)
- UnitedHealth Group Incorporated (UNH)
- AbbVie Inc. (ABBV)
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Consumer Staples
Consumer staples are non-cyclical because they offer everyday essential products such as food, beverages, personal care items, and household goods. These products are necessary for daily living, and their demand remains relatively stable irrespective of economic conditions. For example:
- The Coca-Cola Company (KO)
- Procter & Gamble Company (PG)
- Nestlé S.A. (NSRGF)
- Unilever PLC (UL)
- Walmart Inc. (WMT)
How To Determine If A Stock Is Cyclical?
Determining whether a stock is cyclical or non-cyclical involves analyzing various factors and indicators. Here are some key steps to consider when evaluating the cyclical nature of a stock:
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Industry Analysis
Start by examining the industry in which the company operates. Certain sectors are inherently more cyclical, such as manufacturing, construction, automotive, travel, and leisure.
These industries tend to be more sensitive to changes in economic conditions.
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Revenue and Earnings Patterns
Study the historical revenue and earnings patterns of the company. Cyclical stocks typically exhibit fluctuations in revenue and earnings that correspond to the ups and downs of the business cycle.
.During economic expansions, their revenue and earnings tend to rise, while they may experience declines during economic downturns.
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Sensitivity to Economic Indicators
Assess how the company's performance is correlated with key economic indicators. Cyclical stocks are often influenced by factors like GDP growth, consumer spending, business investment, interest rates, and commodity prices.
If the company's revenue, earnings, or stock price shows a strong correlation with these economic indicators, it suggests a cyclical nature.
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Market Sentiment
Consider the market sentiment towards the stock. Cyclical stocks often attract more attention and perform well when the economy is booming. Conversely, they may face challenges and investor pessimism during economic downturns.
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Do Cyclical Stock Riskier?
Cyclical stocks are generally considered riskier compared to non-cyclical stocks due to their higher sensitivity to changes in the business cycle. Here are some factors that contribute to the perceived higher risk:
Economic Dependence: Cyclical stocks rely heavily on the overall health of the economy. When the economy is doing well, these stocks can experience significant growth and profitability. However, during economic downturns or recessions, cyclical stocks can be more vulnerable to declines in revenue and profitability.
Market Volatility: Cyclical stocks tend to be more volatile in the market. Their prices can experience sharp swings in response to changes in economic indicators, industry trends, or market sentiment. This volatility can create opportunities for gains but also increases the potential for losses.
Business and Industry Risks: Cyclical companies often operate in industries that are exposed to specific risks. For example, manufacturing companies may face risks related to raw material costs, supply chain disruptions, or changes in consumer demand. These risks can impact the financial performance of cyclical stocks.
Timing and Predictability: Successfully timing the purchase and sale of cyclical stocks based on the business cycle can be challenging. It requires accurately predicting economic conditions and knowing when to enter or exit positions. Mistiming these cycles can lead to suboptimal investment returns.
Investor Sentiment: Investor sentiment plays a significant role in the performance of cyclical stocks. During economic downturns, investor confidence may wane, leading to selling pressure on cyclical stocks and further price declines. This sentiment-driven risk can amplify the volatility and downside potential of these stocks.
It's important to note that while cyclical stocks are generally considered riskier, they can also present opportunities for higher returns during periods of economic growth. The level of risk associated with cyclical stocks varies depending on the specific company, industry, and market conditions.
Which Is More Senstitive To Inflation?
Cyclical stocks are typically more sensitive to inflation compared to non-cyclical stocks. Here are the main reasons:
Cost Pressures: Cyclical companies often face increased costs during inflationary periods. Higher inflation can lead to rising prices of raw materials, energy, and labor, impacting the production costs of cyclical industries such as manufacturing, construction, and transportation. As a result, their profit margins may be squeezed.
Consumer Demand: Inflation can affect consumer purchasing power. When prices rise, consumers may reduce their discretionary spending, leading to lower demand for cyclical products or services. This can impact the revenue and profitability of cyclical companies.
Interest Rates: As we've seen recently, inflationary pressures may prompt central banks to raise interest rates to curb rising prices. Higher interest rates can increase borrowing costs for cyclical companies, impacting their investment plans and potential growth.
On the other hand, non-cyclical companies provide essential goods or services that people need regardless of inflationary pressures. These industries, such as utilities, healthcare, and consumer staples, offer products that are considered necessities. Consequently, non-cyclical companies may have more stable demand even during inflationary periods.
Also, non-cyclical companies often have relatively higher pricing power. They may be better positioned to pass on increased costs to consumers through price adjustments without a significant impact on demand. This ability to maintain or raise prices helps protect their profit margins during inflationary periods.
FAQs
Are non-cyclical stocks suitable for conservative investors?
Non-cyclical stocks are often favored by conservative investors due to their stability and consistent demand. These stocks can provide a more predictable investment option for those seeking lower-risk opportunities.
Do non-cyclical stocks offer consistent dividends?
Non-cyclical stocks are known for their potential to provide consistent dividends. Companies in sectors such as utilities and consumer staples tend to have stable cash flows, allowing them to distribute dividends to shareholders regularly.
Do cyclical stocks require more active portfolio management?
Investing in cyclical stocks may require more active portfolio management. Since their performance is closely tied to the business cycle, investors need to monitor economic indicators and make timely decisions to capitalize on favorable conditions and mitigate risks.
Are non-cyclical stocks more stable during economic downturns?
Yes, non-cyclical stocks are generally considered more stable during economic downturns. As they offer essential products or services that people need regardless of their financial situation, the demand for these stocks remains relatively consistent.
