In times of economic uncertainty, many questions arise about the best way to invest.
Investors cannot control the movement of the economy but they can adapt their strategy to try and cope with its ebbs and flows.
The ability to adjust requires an understanding of the relationships between certain sectors and the economy, and of how to invest in cyclical or non-cyclical – or defensive – investments.
A cyclical stock is strongly linked to economic activity. When the economy is in a recession the profits of a cyclical company tend to drop and so too does its share price.
By contrast, when the economy is in a good shape the share price can rise with any profits growth.
A good example of this is the travel and leisure sector. The recession and the subsequent impact it had on individual share prices, such as those of Intercontinental Hotel Group, whose brands include Holiday Inn and Crowne Plaza, is reflective of the hotel industry as a whole.
In times of economic hardship, companies such as these can suffer as consumers look to cut their cloth and forsake luxury goods and services to focus on the essentials of life.
On the other hand, a defensive or non-cyclical stock is where profits growth and the share price have a very low correlation to economic activity. No matter how the economy performs, the revenues, earnings, cash flows and often the shares of the company remain relatively stable.
National Grid is considered a non-cyclical stock – people still need to use electricity to power their appliances and homes, even during a recession – and its performance over the past 10 years reflects this.
Non-cyclical stocks will outperform cyclical stocks in a recession and can help protect a portfolio, but is this too conservative a tactic during times of economic growth?
If you are an investor with a more conservative approach to risk, non-cyclical stocks can help to achieve a stable performance from your portfolio.
However, you should understand that this relative safety often comes with a price during periods of economic growth and you may be missing opportunities in a rising market.
By keeping an eye on the business cycle of your current or potential investments, and by understanding the concept of cyclicality, you have the potential to take advantage of these different economic phases.
Emma Plumpton is an investment manager with stockbroker Redmayne-Bentley in Huntly and can be contacted on 01466 799444