Understanding the cyclicality of sectors is one of the most important parameters to look at before investing in a company. This is because cyclical sectors perform in accordance with how the economy is performing whereas defensive sectors are the ones that are not (or least) affected by the performance of the economy. If you look at markets over the last 11 months, one would note that the leaders have changed periodically for the markets. Earlier, when economic uncertainty was high Pharma, FMCG and IT led the charge for the markets, but as soon as economy started opening up, cyclicals soon joined the party. Meanwhile, the defensives took a back seat.
Before we delve into details of understanding cyclicals v/s defensives, we must understand that economies around the world tend to move in cycles and have different phases like expansion, peak, recession, trough. This has been the case for centuries, although the tenure of each phase tends to differ in every cycle.
During the expansion phase, everything looks hunky-dory for businesses as the economy is expanding which suggests that most businesses are growing, leading to higher income which leads to more employment until it hits a peak. The higher aggregate demand eventually causes inflation to rise which leads the central banks to step in and hike interest rates to contain inflation which in-turn impacts growth momentum. So, during the expansion phase, there is no worry for most businesses.
In fact, high cyclical sectors tend to do even better when the economy is expanding. However, the problem arises during the recession phase where the growth is slowing and certain sectors are much more impacted than the others. This is where the segregation of sector comes in and most analysts term it as being defensives or cyclical.
Let’s put this into perspective. Defensive sectors are basically businesses that are least/not impacted by economic cycles like Pharma and Consumer Staples. Would you stop taking medicine? Would you stop eating salt, milk, biscuits? Would you stop applying soaps, shampoos, toothpaste? No, but some amount of downtrading is possible but would anyone really stop using these? The answer would be no.
And now with the whole digital wave and rising internet penetration, one can also add telecom to that list. Can we live without 4G / Internet?- Hell no. Therefore, defensive sectors are usually favoured by investors during the economic downturn or increased economic uncertainty.
Let’s come to the cyclical and this is where it gets tricky because most businesses are cyclical in nature but it’s the intensity is what should matter to the investors. High cyclical sectors are more vulnerable during the recessionary phase than less cyclical ones. Therefore, the degree of cyclicality dictates the impact. During the times when businesses are going down the hill and job uncertainty rises, would you spend on discretionary items like consumer durables, auto, and real estate? No, hence the demand is affected leading to a slowdown in these sectors.
Within sectors as well the intensity of impact could differ. For example, in autos two-wheelers are less cyclical than commercial vehicle, in real estate residential real estate can be considered less cyclical than commercial real estate. The financial sector is also one of the cyclical ones as when the economy slows, the loan growth gets impacted and the risk of a rise in bad loans increases since businesses are not doing well.
The other sectors which are highly sensitive to business cycles are commodity-driven sectors like Oil & Gas, Metals & Mining sectors. When the economy is in contraction, the demand for essential commodities is also impacted heavily leading to a sharp slowdown in these companies. The Airlines & Hotels sector is also highly impacted during downcycle as lower disposable income leads to a sharp slowdown in travel and other related sectors.
Cyclicality can change as well
Some sectors cyclicality can also change depending on changing trends or other factors. For instance, the IT sector was also considered cyclical in nature as IT spending was a function of how the business has performed. But now due to the pandemic and increased efforts towards digitization, the IT sector has definitely moved a few spaces towards being defensives.
Therefore, while selecting a stock for investment one must know the sector and its cyclicality as the higher the cyclicality the deeper is the impact on the business (in-turn the stock price) during an economic recession. It does not mean that high cyclical sectors cannot be good investment picks, it is just that these sectors require extra attention as economic tailwinds are not there during the recessionary phase and the company has to step up its game to maintain or grow its business.
We recently tweeted about how investor preference has quickly shifted from defensive to cyclicals. Read more on this below.
Just a thought!— monergise.com (@monergise) February 11, 2021
Can this be the shortest bull cycle ever?
Here is why
Usually every bull market starts off with defensives being favorites and slowly moving to cyclicals.
This time the switch from pharma to consumer to finance to infra/metals has been pretty fast.