It can be argued that all shares are somehow cyclical because their profits will follow a pattern of some description over long periods of time. But when investors talk about cyclical shares they are referring specifically to companies whose profits are tied to the way that an economy moves.
Property developers and Real Estate Investment Trusts (REITs) are good examples of cyclical shares. For example, when economies are strong, demand for property are likely to rise. Consequently property developers such as City Developments (SGX: C09) can charge higher prices for their apartments, condos and houses.
Similarly, REITs that include CapitaMall Trust (SGX: C38U) can ask for higher premiums for their units, which could translate into higher profits. However, when economic conditions are poor, then developers and landlords may have trouble shifting their units at any price.
Banks shares such as DBS Group Holdings (SGX: D05) can be cyclical in nature too. During the boom years, banks can lend more, charge more and, consequently, make more. But when economic conditions deteriorate, they can’t. Sir Gordon Woo of Hong Kong’s Hopewell Holdings summed up the cyclical nature of banks quite pithily: “Whenever there is a financial crisis, it is always the banks that get hit.”
Buy high, sell low?
Interestingly, investing in cyclical shares requires a modicum of contrarianism. In the view of Peter Lynch who made many investments in cyclical companies, cyclical investors need to think differently. He said that with most stocks, a low PE ratio is a good thing, but not with cyclicals. When the PE ratios of cyclical companies are very low, it can be a sign that they are at the end of a prosperous interlude.
Soon, he reckoned, the economy will falter, and the earnings of the cyclical will decline at breath-taking speed. As more investors head for the exits, the stock price will plummet. He warned that buying a cyclical after several years of record earnings and when the PE ratio has hit a low point is a proven method for losing half your money in a short period of time.
Conversely, he reckons that a high PE ratio, which with most stocks is regarded as a bad thing, may be good news for a cyclical. Often it means that a company is passing through the worst of the doldrums, and soon its business will improve.
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