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Why Are Non Cyclical Stocks Less Risky Than Cyclical Stocks?

By Edited Dec 23, 2015 2 0

Nowadays, investing is complicated. It is not seen as a way to “make your money work for you” anymore. Since the economic downturn of 2008, most investors are more cautious when it comes to investing in stocks, mutual funds, and even bonds. The majority of investors lost large amounts of money throughout the economic downturn. This forced many of them to rethink their investment strategies.

There is still one strategy out there that many investors believe mitigates risk. It is a strategy used by Canadian billionaire, Stephen Jarislowsky. The strategy differentiates between cyclical and non-cyclical stocks.

First, let’s start by defining what a cyclical stock is. Cyclical stocks highly correlate with economic activity. When the overall economy is in a recession the profits of a cyclical company tend to drop and at the same time its share price does as well. Cyclical stocks are made up of companies that deal directly with construction, luxury items, electronics and automobiles. Pretty much, products that you wouldn’t purchase everyday. Furthermore, they are products that are consumed and/or ordered less during an economic downturn.

Toothpaste

On the other hand, when a company is non-cyclical, it is known as a “defensive stock”. Non-cyclical stocks which have “defensive” features, tend to perform well, even in an economic downturn. These companies produce products such as toothpaste, deodorant, paper towels and just about anything that is in your kitchen or bathroom. Moreover, these types of companies typically do not see major earnings decreases during difficult economic times.

Electric and gas utilities are another good example of non-cyclical companies. They deliver gas and electric to thousands upon thousands of customers in a given area. Most of them are regulated by a state or local government, so their earnings are usually consistent. These companies also are known to pay out large dividends to shareholders over the long-term. 

One good example of a cyclical industry is the automobile sector. Would a person really go out and purchase a new car during an economic downturn? In addition, would a person even purchase a used car during these tough times? Most likely not. On top of that, car manufacturers' earnings typically slow down greatly due to lower demand during these times.

New Car

Another example of a cyclical sector would be IT (Information Technology) companies. A company is more reluctant to invest in renewing its computer system during economic turmoil. Many companies may end up either keeping their older systems or slightly upgrading their current systems, this would allow them to avoid using IT companies altogether during a severe recession.

The construction industry is also considered to be cyclical. This industry is tied into many different sub-sectors including home building, construction machinery, lumber, cement, and steel. All of these sub-sectors tend to correlate directly with the demand in the housing industry. In 2008, this was one of the sectors that took an enormous hit.[1]

Additionally, some other cyclical sectors include international maritime, mining (copper as well as  other minerals), home appliances, aluminum, rubber, and chemicals. All of these sectors tend to do poorly during an economic downturn. In rare scenarios, a company may have made alternative investments which may mitigate losses in a certain area. Although this may occur once in a while, it is actually pretty rare. When a specific industry typically goes into free fall, it is usually difficult for it to recover. Furthermore, cyclical stocks have a lower chance of paying out dividends to shareholders during these economic slowdowns.  

tanker
  

Now, there are some sectors which tend to confuse investors. For example, is the oil and gas industry cyclical or non-cyclical? Doesn't everyone always need oil? Yes, that is true, therefore, the oil and gas industry is usually considered non-cyclical. That is especially true if the oil company operates as vertically integrated. Some oil and gas companies will only operate in the upstream (drilling and exploration). Vertically integrated oil companies operate in upstream, midstream and downstream. Ultimately, the large operations that these companies have mitigated their risks involved with declines in oil prices, especially if they have a strong downstream business.

gas

Another tricky industry are railroads. Many investors will label them as cyclical. They may have some cyclical characteristics, but railroads are actually extremely diversified. They carry anything from refined products to vegetables. Moreover, they typically change what they transport based on supply and demand. This enables many large railroads to operate with a consistent profit. Even through economic hardship, many railroads are able counter these economic difficulties by transporting whatever is in high demand.

Identifying whether a sector is cyclical or non-cyclical might seem easy at first. However, it can be a bit harder than you think. If an investor decides to stick with “simple products that stay in demand” it will remain easy. As an investor diversifies further into more companies, their risk of going into a cyclical stock increases. Now, there is no doubt that there are some good cyclical stocks out there, and they most likely performed just as good or even better than the Dow Jones over a given period of time. Ultimately, that does not mean that all cyclical stocks will perform the same way.

When one decides to invest for the long term, there are dozens of strategies and techniques that could be used. The cyclical vs. non-cyclical strategy is just another one of them. Remember, many times an investor will find a sector that may look like a non-cyclical stock and may really be a cyclical stock. In other words, a certain company may look appealing, but may be tied to a certain commodity that could  decrease in value, which would ultimately lead to the company’s revenue and/or earnings to plummet.

Jarislowsky has always been an advocate of investing in non-cyclical stocks. He has had immense success with this strategy and in his book  “The Investment Zoo: Taming the Bulls and the Bears” he speaks about this strategy constantly.

Investors may want to take the time to look more into detail about this strategy because it was spoken about many times right after the 2008 financial crisis. Some investors wish they would have listened to Jarislowsky back in the day because they may have had the capability to counter some of their losses.

 

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Bibliography

  1. Stephen A. Jarislowsky The Investment Zoo: Taming the Bulls and the Bears . New York City: Transcontinental Books, 2009.

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