The Motley Fool

What Is: Cyclical Stocks

It can be argued that all companies 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 can charge higher prices for their apartments, condos, and houses.

Similarly, REITs 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 can be cyclical in nature too. During the boom years, banks can lend more, charge more and, consequently, make more, all while seeing low loan losses. But when economic conditions deteriorate, those good times don’t continue. All banks will suddenly see lower demand for their loans while loan losses rise. Banks that didn’t manage their risk well during the economic upturn can get particularly hard during this kind of cyclical reversal.

Buy high, sell low?
Investing in cyclical shares requires a contrarian bent. 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 P/E ratio is a good thing, but not with cyclicals. When the P/E 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 P/E 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.