Investors in Singapore are treated to a buffet of companies to invest in when they first approach the local stock market – but let’s not forget that there are also many other stocks listed on stock exchanges around the world. The first thing we as investors should ask when reviewing a company is whether it is cyclical, and if so, how much is it affected by the cycle and should it still be considered for investment?
Defining what cyclical is
Let’s start off by defining what a cyclical company is. Every economy has a business cycle, and when times are good (i.e. during boom periods), companies expand by building more factories and plants, producing more and increasing the total supply of goods and services to be sold to customers. Conversely, when times are bad (i.e. during recessions), companies will do the opposite – they retrench staff, cut down on production by moth-balling factories, and lower the overall supply of goods and services offered as customer-demand falls due to a lower propensity for spending.
Strictly speaking, hardly any industries are completely immune to business cycles, but some industries tend to have more severe boom-bust experiences. Companies which are exposed to industries with more pronounced up-and-down swings are labelled as cyclical companies. It is typical of cyclical companies to experience sharp swings in demand – splendid results in good years but terrible numbers in bad ones.
Some examples of cyclical industries include commodities (oil and gas), electronics (semi-conductors), real estate, and shipping. In particular, the shipping industry collapsed during the Global Financial Crisis of 2008-2009 and has yet to recover to its former glory. Many shipping companies went bust when freight rates collapsed and the remaining players struggled for years with big losses and a severe erosion of shareholders’ equity.
How investors should approach cyclical companies
As investors, we should keep an eye out for industries which tend to ramp up capacity in tandem during good times, as this implies that the companies within the industry may not be behaving rationally and thinking long-term. This kind of collective corporate behaviour results in volatile cycles and it is easy for us to see all our gains evaporate when things turn sour – we may even up losing our invested capital if the companies we’re invested in file for bankruptcy.
The conclusion is that the average investor is better off avoiding cyclical companies, unless he has superior information on the industry or is able to time the cycle to perfection. Instead, he can choose to invest in resilient sectors such as utilities, healthcare, and education.
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