Investing in Cyclical Stocks: Advantages and Disadvantages

Imagine being on a Ferris wheel: one minute you're on top of the world, the next you're at the bottom (and eager to head back up again). Investing in cyclical companies is much the same. However, the time it takes to go up and down—also known as a business cycle—can last years.

Identifying these companies is fairly straightforward. They often exist along industry lines. Automobile manufacturers, airlines, furniture, steel, paper, heavy machinery, hotels, and expensive restaurants are some examples of cyclical companies.

Profits and share prices of cyclical companies tend to follow the economy's ups and downs; that's why they are called cyclical. When the economy booms, sales of goods—such as cars, plane tickets, and fine wines—tend to thrive. On the other hand, cyclical stocks are prone to suffer in economic downturns.

The Advantages of Investing in Cyclical Stocks

Before selecting a cyclical stock, it makes sense to pick an industry due for a bounce. In that industry, choose companies that look especially attractive. The biggest companies are often the safest. Smaller companies carry more risk, but they can also produce the most impressive returns.

Given the up-and-down nature of the economy—and, consequently, that of cyclical stocks—successful cyclical investing requires careful timing. It is possible to make a lot of money if you time your way into these stocks at the bottom of a down cycle just ahead of an upturn.

When does it pay to buy cyclical stocks? Predicting an upswing can be difficult—especially since many cyclical stocks start doing well many months before the economy comes out of recession. Buying requires research and courage. On top of that, investors must get their timing perfect.

The Disadvantages of Investing in Cyclical Stocks

While it's possible to make a lot of money if you time your way into these stocks at the bottom of a down cycle just ahead of an upturn, investors can also lose substantial amounts if they buy at the wrong point in the cycle.

Cyclicals respond more violently than growth stocks to economic changes. They can suffer mammoth losses during severe recessions and can have a hard time surviving until the next boom. But, when things do start to change for the better, dramatic swings from losses to profits can often far surpass expectations. Performance can even outpace growth stocks by a wide margin.

All companies do better when the economy is growing, but good growth companies, even in the worst trading conditions, still manage to turn in increased earnings per share year after year. In a downturn, growth for these companies may be slower than their long-term average, but it will still be an enduring feature.

Strategies for Investing in Cyclical Stocks

Falling interest rates are usually a key factor behind the success of cyclical stocks. Since falling rates normally stimulate the economy, cyclical stocks fare best when interest rates fall. Conversely, in times of rising interest rates, cyclical stocks fare poorly.

But it's important to keep in mind that the first year of falling interest rates may not be the right time to buy. Investors will usually have better luck buying in the last year of falling interest rates, just before they begin to rise again. This is when cyclical stocks tend to outperform growth stocks.

Many investors look for companies with low P/E multiples. However, when investing in cyclical stocks, this strategy may not work well. Earnings of cyclical stocks fluctuate too much to make P/E a meaningful measure; moreover, cyclical stocks with low P/E multiples can frequently turn out to be a dangerous investment. A high P/E normally marks the bottom of the cycle, whereas a low multiple often signals the end of an upturn.

For investing in cyclical stocks, price-to-book multiples are better to use than the P/E. Prices at a discount to the book value offer an encouraging sign of future recovery. But when recovery is already well underway, these stocks typically fetch several times the book value.

Insider buying, arguably, offers the strongest signal to buy. If a company is at the bottom of its cycle, directors and senior management will, by purchasing stock, demonstrate their confidence in the company's full recovery.

Finally, keep a close eye on the company's balance sheet. A strong cash position can be very important, especially for investors who buy recovery stocks at the very bottom, where economic conditions are still poor. A company with a large cash position can survive longer, giving investors more time to confirm whether their strategy was a wise one.

The Bottom Line

Don't rely on cyclical stocks for long-term gains. If the economic outlook seems bleak, investors should be ready to unload cyclical stocks before they tumble and end up back where they started. Investors stuck with cyclicals during a recession might have to wait a long time before the stocks return to their former value.