With hundreds of shares to pick from and over 30 share sectors, identifying Cyclical and Defensive stocks can help in understanding the investment landscape and opportunity for investment.
Shares listed on the Stock Exchange are attributed a ‘sector’ – a common area that enables like-for-like companies to be grouped. There are over 30 of them, ranging from Banking, Health Care and Related Services, Mining through to Support and Tobacco.
A simple distinction can be made when picking between shares – those are those that fall into the Cyclical category and those that fall into the Defensive category.
Whether a share can be viewed as defensive or cyclical depends on its movements in relation to the wider economy. The general view is Cyclical Stocks move in tune with the status of the economy and will move in cycles. Defensive stocks are less vulnerable to problems in the economy – they represent shares in companies that provide services that the population will continue to need.
Cyclical Stocks: more volatile, move in line with economy
Cyclical Stocks are more dependent on the state of the economy so they will be more volatile – going through a cycle from growth, peak, recession and recovery. If the economy falls, Cyclical Stocks tend to fall. Therefore Automotive and Parts, Tourism and Leisure and Retailers (High-End, Brick & Mortar) are the type of sectors likely to suffer.
If you are considering investing in a Cyclical Stocks, it’s wise to understand how sound a business is overall – keep an eye on its net debt to ensure that the hard times it will be subjected to won’t risk the firm collapsing.
The Property sector perhaps sums Cyclical Stocks well. When the economy is booming, employment levels of high and there is increased demand for housing. When an economy is falling, there is less demand for homes and prices fall. This will impact the bottom-line of Housebuilders within the Property sector.
Defensive stocks: less volatile, resilient and continue to be in demand
When the economy is in trouble or experiencing a downturn, Defensive Stocks tend to shine and perform better. This is because the services and products from Defensive Stocks will continue to be required. We will all continue to need Household Utilities such as water and electricity as well as Food (Food & Drug Retailers).
The challenge in picking Defensive Stocks is to understand which ones are cheaply valued and are therefore likely to increase more significantly in value when their demand increases in an economic downturn.
Some stocks can blur the line between Cyclical and Defensive – for example, Miners generally fall into the Cyclical Stock category, but Gold Miners tend to rise strongly in value during a downturn due to the increase demand for Gold and geneal ‘rush to safety’.
Helping to build a balanced portfolio
Cyclical and Defensive Stocks are a great example of the fundamentals of a Balanced Portfolio – some shares will perform badly but some shares will perform well. They also highlight the vital link between companies, share prices and the wider economy.
The distinction provided helps to bring greater logic to picking shares – any Investment Portfolio should spread its risk between more risky investment rewards and those with less risk.