How to Invest In Cyclical Companies

There are many ways to invest successfully. Value investing, momentum investing, and growth investing are just some of the more common styles you might hear about. While it might be too much to ask for someone to be well-versed in all approaches, it’s fortunate that as investors, we can be focused on only one approach and still be very successful over the long term.

Now, investing in cyclical companies is one of the more commonly-used techniques for contrarian investors. The idea is to invest in companies that belong to industries that are facing temporary headwinds and slowing down due to the natural motion of a business cycle. Contrarian investors will then buy into them and wait for the industry to recover.

What is a typical business cycle?

Let’s use a cyclical company like the full-service carrier Singapore Airlines (SGX: C6L) as an example. When the general economy picks up and the global population becomes richer, people will be able to travel more. This will lead to greater profits for the entire industry, SIA included.

This might go on until the industry reaches a point where its players will need to expand their fleets to keep up with the demand. Most airlines will then need to order more aircrafts and since planes don’t come cheap, it’s common to see airlines borrowing money to finance these purchases, in turn leading to an increase in debt levels for various airlines.

But, as every airline starts projecting more and more growth, the supply of aircrafts might surpass the travel-demands of passengers. When this somewhat inevitably happens, airlines will have to slash prices to attract customers.

As the price war intensifies, weak players with overleveraged balance sheets might find themselves facing bankruptcy. As more companies face bankruptcy, the supply of fleets in the market will decrease.

The industry might also consolidate, as industry players with stronger balance sheets start acquiring the weaker ones. The governments in different countries might also start bailing out their national carriers. Things will slowly go back to normal and the cycle will once again restart.

Where do we start?

To be successful with cyclical companies, we might need to have the courage to invest when we see companies in a cyclical industry facing threats of bankruptcy and nationalization (the latter occurs when governments take over a company in the private sector in an effort to save it). Investors also have to be able to spot the companies that will come out of the recession alive and stronger, and this point ties back into the importance of a cyclical company having a strong balance sheet.

The above seems easy enough at first glance. But make no mistake though, all these uncertainties makes investing in cyclical companies challenging and emotionally draining.

A Foolish take

So the next time you examine the stock market, you might want to see what companies belong to industries that are facing a temporal slowdown (a company that makes pagers exclusively during the advent of the mobile phone can’t be considered cyclical as the entire product line of pagers would be rendered almost extinct).

How is the market reacting to them? Which companies do you feel are currently near the bottom of its business cycle? How might the companies be performing during the upswing in the cycle? If you are able to answer these questions about the companies you are looking at, you might be able to get a sense of what investing in cyclical companies is all about.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.