Understanding Cyclical Stocks

Hey everyone!

I want to talk about something today that a lot of new investors don’t often pay attention to even though I believe it’s essential for a long term successful investment program. This is the business cycle.

Any company or business depends relies first and foremost on the economy of its country or market in order to function. If the economy is good, business tends to be good and vice versa. Now the business cycle is the natural expansion and contraction of the economy, driven by demographics, expectations, credit and monetary policy among other things. It’s the natural cycle of boom and bust. You can read more about it here.

Now almost every business is sensitive to the business or economy cycle at some level but some of them are acutely more sensitive than others. There are some businesses that do really well when the economy is expanding but do very poorly when the economy is contracting. One popular company that falls into this category is Disney. When the economy is growing rapidly, people spend more on movies, entertainment, vacations to Disney theme parks, toys and recreation. Disney makes more money. When the economy contracts, people tend to cut non-essential expenses like the above, have staycations and save money and so Disney doesn’t do as well. Major car companies, appliance makers and airlines also tend to be cyclical.

Now when investing in cyclical companies, one has to pay attention to where the broader economy is in the cycle. During boom periods like the one we’re currently in (and some say at the peak of), earnings rise for cyclical companies, and their multiples (the stock price in relation to the underlying earnings) also expands giving the company a high valuation. When the cycle turns downwards, they make less money and investors tend to sell them off leading to lower multiples and collapsing valuations until the next rise. And if the downturn is bad enough, cyclical companies can run into major trouble and sometimes not make it out alive. I’m not sure if many of you remember that Obama had to bail out the American auto industry as part of the fallout of the last recession.

All of this means that when you analyze a company, you do have to think of its business right off the bat, whether it is cyclical or not and where the economy is currently and that will tell you the approach to take in your valuation and possible investment.

I hope you read more on that and use that to your benefit.

Happy investing.

Im still raising funds for a real estate opportunity I’m pursuing so if you want to know more about it, read this.

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