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How to Invest in a Cyclical Stock

Value investor with a deep passion for understanding and a desire to improve results over time.

What is a cyclical stock?

What is a cyclical stock?

Classifying Stocks

In a vast universe of stocks you might consider buying, there's a great deal to be said for classification and organization. This means figuring out various different categories that stocks can go into, such as GICS (Global Industry Classification Standards). GICS will tell you what sort of industry the underlying company is in, but that only tells you so much about the stock.

In his magnum opus One Up on Wall Street, Peter Lynch puts forth some important concepts for classifying stocks. One of the most helpful of these is to break the stocks into behavior-based classifications, dependent on how the stock itself is expected to behave based on certain underlying factors.

Let's zero in on cyclical classification, in heavy contrast with fast growers or stalwarts. Let's take a quick look into why they tend to behave differently and how we can use that knowledge to know when to buy and sell cyclical stocks.

Cyclical stocks are the most roller-coaster-like of all classifications.

Cyclical stocks are the most roller-coaster-like of all classifications.

What Makes a Cycle Happen?

One of the most basic tenets of economics is the fundamental concept of the relationship between price, supply, and demand. In a nutshell, if supply stays constant and demand rises, so goes the price; vice-versa, if supply is constant and demand drops, the price will also tend to drop.

Likewise, supply can rise and cause the price to fall, or it can fall, and the price can rise in response. This is pretty intuitive: scarce things tend to cost more than very common things, and this is unlikely to be a surprise to anyone raised in a society with relatively free markets.

Exxon: a classic cyclical business

Exxon: a classic cyclical business

Things get a little more interesting when the cycle becomes self-perpetuating, as happens with everything from our total economy to individual stocks to the stock market as a whole. What does this mean? It means that the participants in the market themselves can create the next phase of the cycle by their mere participation in the market.

If oil is $100 a barrel right now after being at $50 last year, buyers and consumers will naturally perceive the price to be expensive at the moment. This motivates people to be cautious when considering buying, and maybe even to buy less oil, assuming they can get by with another energy source, or they can just conserve oil for a while and consume less. Naturally, if fewer people are willing to buy the oil at $100 a barrel, that means the people and entities selling the oil are likely to drop the price in order to get additional buyers.

Finding the Cheat Code

As the above chart clearly shows, the same thing can happen to the underlying business earnings of any company producing the commodity in question. Exxon Mobile is one of many obvious examples of earning cyclicality; if they have a couple of good years, they seem bound to have a couple of bad years to follow up. While not all stocks follow earnings directly, many tend to do so, especially commodity-based stocks, like oil companies or metal miners.

However, commodity companies are far from the only types of stocks that tend to be cyclical, so you need to actually take a few moments to analyze past tendencies. See if you can figure out why the stock is cyclical, so you can understand a good time to buy it. Clearly, we want to buy closer to the bottom than to the top of the cycle, since the price of the stock is bound to drop precipitously once the current peak has been reached, and you really don't want to buy a cyclical anywhere near the peak.

Why Do Cycles Happen?

A few reasons a stock might be cyclical include:

  • The central offering of the company is a commodity or something commodity-dependent
  • An industry or GICS sector might have a tendency to be in or out favor, depending on recent price action or global events
  • A stock is closely tied to the economy, which is itself cyclical in nature (the company does well while the economy is doing well but does poorly during a recession or downturn)

Understanding why a stock moves up and down so much with regularity can help you figure out when to buy and sell. It's kind of like having a cheat code for the cyclical trade game.

Fish Jumps and Flexibility

You might already know that I'm the sort of investor who has no problem with a very long time horizon. As a value-oriented stock picker, I am comfortable with an ownership mindset, meaning I'm cool with owning a stock for a decade (or even longer!) since I'm an owner of the company.

However, allowing Mr. Market to advise you on when to sell a stock you own can be tremendously beneficial under the right circumstances, particularly when you can keep in mind that irrationality can swing heavily in your favor from time to time. If you can change lanes from long-term investing to medium-term cyclical trading, you can take advantage of such perturbations in the market.

The jumping fish concept I've outlined in the past can be a terrific guide to use with cyclicals in particular since the volatility often presents ridiculous returns in a short period of time. If you can exit up 30, 40, or 50 percent up from a cyclical stock that then falls down below where you bought it, that's going to feel like a pretty good decision in retrospect. While you won't always nail this, you tend to get better over time as you observe more cyclicals.

This sort of mental flexibility, of being able to turn from the mindset of holding for a decade or more to one of selling after a month, can be tough to develop at first. If you've read Buffett, Munger, Graham, and the value investing soothsayers, they'll tell you that in the long term, the market is a weighing machine. However, the market also presents you with irrational opportunities from time to time, and indeed it can pay well to take advantage of these fish jumps. Cyclical stocks have this characteristic more so than any other type of stock.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2021 Andrew Smith