Investors cannot control the cycles of the economy, but they can adjust their
investing practices with its ebbs and flows. Adjusting to economic transitions
requires an understanding of how industries are characterized by their
relationship to the economy. It's important for you to know the fundamental
difference between cyclical and non-cyclical companies so that you can
distinguish between sectors that are affected by economic changes and those
that are more immune. Here we look at the industries that reside within these
categories, and identify where it's best to put your money when the economy
starts to decline.
What Does Cyclical and Non-Cyclical Mean?
These terms, cyclical and non-cyclical, refer to how highly correlated a
company's share price is to economic fluctuations. Non-cyclical stocks
repeatedly outperform the market when economic growth slows, while cyclical
companies are highly correlated to the economy. The non-cyclical securities,
also called defensive stocks, experience profit regardless of economic
gyrations because they produce or distribute goods and services we always need:
food, power, water and gas. The sales of companies with cyclical stocks, on the
other hand, depend on whether or not the economy is strong; sales will thrive
when people have extra income to spend on luxuries, and they'll decline when
the economy slumps.
The Concept
The difference between cyclical and non-cyclical industries is simply the
difference between necessity and luxury. There are certain items we can't live
without and won't likely cut back on even when times are tough. The stocks of
companies producing these things are non-cyclical and are "defended" against
the effects of economic downturn, providing great places to invest when the
economic outlook is sour. For example, household non-durable goods - a fancy
term for the things you use up quickly around the house - such as toothpaste,
soap, shampoo and dish detergent may not seem like essentials, but you can't
really sacrifice them. Most people don't feel they can wait until next year to
lather up with soap in the shower.
Contrast this to the new car you've had your eye on. Although it's more
exciting to buy a new car than soap, you are more likely to postpone the car
for a year or two if your finances feel the effects of an economic slump.
Another good example of a cyclical industry is fine dining. When things are
good people are more inclined to take the family out for an expensive meal;
macaroni and cheese, on the other hand, has to suffice when finances are
depressed. Other examples of cyclical industries are manufacturing, the steel
industry, travel and construction - the sectors that produce things we can live
without when money is tight. These are exactly the types of industries you want
to avoid when the economy turns sour.
Charting a Cyclical vs. Non-Cyclical Company
Below is a chart showing the performance of a highly cyclical company, the Ford
Motor Co. (blue line), and a classic non-cyclical company, Florida Public
Utilities Co. (red line). This chart clearly demonstrates how each company's
share price reacts to downturns in the economy.
Notice that the downturn in the economy from 2000 to 2002 drastically reduced
Ford's share price, whereas the growth of Florida Public Utilities' share price
hardly batted an eye at the slowdown.
Non-Cyclical Industries - Safety in Turbulent Times
Let's look more closely at examples of non-cyclical industries so that you know
where to start looking when a recession is on the horizon.
Utilities
An excellent example of a non-cyclical industry is utilities, which can help
investors avoid losses when highly cyclical companies are suffering. For
instance, selling your Caterpillar stock and buying a share in, say, Minnesota
Power Inc. is a type of maneuver that investors have used for years during
economic downturns. If times become tough, there's not much money for building
projects, so construction companies are less likely to purchase heavy
machinery. But, no matter what, people's top priority will always be to have
power and heat for themselves and their families. By providing a service that
is consistently used, utility companies grow conservatively and do not
fluctuate dramatically - these companies provide safety, but this also means
they are not going to skyrocket when the economy experiences growth.
Household Non-Durables
As we mentioned before, people will always need certain essentials around the
house. From deodorant to bleach, we can't really sacrifice the things that keep
us and our living spaces clean. For this reason, companies such as Procter &
Gamble, Colgate-Palmolive and the Gillette Co. are all attractive investment
choices when the economy is in the dumps.
Tobacco
It is easy to see why tobacco companies are considered non-cyclical: it's hard
for smokers to stop smoking, even during a recession. So a company such as
British American Tobacco will exhibit more stability during these times. Even
though tobacco is considered a "sin" industry and may be unethical for some
investors, it does have the characteristics of a non-cyclical sector.
Conclusion
Learning how to predict economic cycles is not within the scope of this
article, but simply realizing that different industries respond differently to
economic fluctuations can help keep your money safe. When the economy cools
off, the cyclical companies will be hit the hardest, so seek out stable
companies that produce things you can't live without.