Cyclical versus defensive stocks

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To build a portfolio of stocks on the stock exchange, you have to know the distinction between a cyclical and a defensive stock. To reduce your risk on the stock markets, it is important to diversify your equity portfolio. How well you choose your stocks on the stock market depends on your investor profile and your level of risk aversion.

Cyclical stocks

A cyclical stock is one that is strongly linked to economic activity and the economic situation. In times of recovery and expansion, cyclical stocks are the first to benefit. Their stock market prices rise sharply.

In times of economic slowdown and recession, however, cyclical stocks are the first to be affected. Companies see their activities decline sharply and this has an impact on the share price. The drop can then be severe.

Cyclical stocks include companies in the Banking, Buildings and Building Materials, Automotive, Industrial Goods and Services, Household and Personal Care, Media and Entertainment, Technology, Distribution (equipment, textiles, etc.), Travel and Recreation, Metallurgy and Mining business sectors.

In times of crisis, for example, it is easy to understand why building construction falls. Household incomes decline and employment security is lower. People therefore postpone purchasing their home pending more favourable conditions. For construction companies, there is therefore a fall in the order book, a drop in turnover. The sanction is immediate for the stock market price.

These cyclical stocks will therefore outperform stock market indexes during periods of expansion and recovery (market gains) and underperform during periods of overheating and recession (market downturns).

Defensive stocks

A defensive value is a value that has little correlation with economic activity or the economic situation. These stocks are said not to be affected by crises. In periods of overheating or recession, defensive stocks remain solid. Their activity is not impacted very much and the share price is therefore more stable.

During a period of recovery or expansion, the activity of defensive companies increases but very little. They benefit from the market euphoria but to a limited extent.

Defensive stocks include companies in the agri-food, health, oil and gas, chemicals, insurance, utilities and telecommunications sectors.

Let us take health as an example. In times of crisis, households will not stop consuming health products/services. There is a certain stability in the turnover of companies in the sector and the share price therefore remains more or less stable.

These defensive stocks will therefore underperform stock market indexes in periods of expansion and recovery (rising markets) and overperform stock market indexes in periods of overheating and recession (declining market).

Classification is sometimes difficult

Classifying a company as a cyclical or defensive stock is sometimes complicated. In fact, within the same sector of activity, some companies are cyclical and others defensive. We can take the example of luxury products. They are consumer goods and must therefore be sensitive to the economic situation. However, companies specializing in luxury goods (e.g. LVMH) have weathered the crisis very well because of their development in emerging countries. We can therefore consider that luxury goods companies are part of defensive stocks since they have not been significantly impacted by the bad economic situation.

Conversely, we can take the example in the sector considered to be defensive, the agri-food sector, which has seen many of its companies heavily impacted by the crisis. Distributors must be distinguished from suppliers. Distributors are generally quite resilient, but suppliers have been hit hard by the economic downturn. Many jobs have been lost and factories closed. The causes cited are the rising cost of raw materials and the ever-increasing pressure on margins from large distribution groups.

Another example is the community services sector (defensive sector) which was hit hard by the crisis due to the explosion of sovereign debt.

The classification of defensive and cyclical stocks is therefore carried out on a case-by-case basis, even if there are major trends in the sectors of activity as a whole. With the evolution of the various economic variables, it can also be seen that certain sectors of defensive activity can become cyclical and vice versa.

Diversification of your stock market portfolio

To invest well in the stock market, you need to diversify your investments. This reduces your risk. If you have a long-term investment horizon, you should therefore include defensive and cyclical stocks in your stock market portfolio. The lower your level of risk aversion, the more cyclical you can incorporate. For good diversification of your stock market portfolio, you should also choose different sectors of activity and geographical areas.

If you have a medium-term investment horizon (more active investor), you must take into account the economic situation. Is the economy in a phase of overheating, recession, recovery or expansion? If we are in a phase of overheating or recession, you must turn to defensive stocks. If we are in a period of recovery and expansion, cyclical stocks are more attractive.

Choosing your stocks

There are two ways to choose your stocks on the stock exchange:

Macroeconomic approach (called the downwards or top-down approach)
: This approach involves studying the economy as a whole. You then need to identify what phase the economy is in (recovery, expansion, overheating or recession). Depending on your analysis, you can then orientate yourself towards the appropriate economic sectors. Finally you need to select the strongest stocks within these industries. This macroeconomic approach requires knowledge of the economy in general.

Microeconomic approach (called the upwards or bottom-up approach)

: This approach consists of prioritizing different stocks to find the current good deals. So you're more interested in the fundamentals of the business than the state of the economy in general. Once you have selected your stocks, you pay attention to each stock's sector of activity to ensure proper diversification. This microeconomic approach requires knowledge of financial analysis.

Reminder : This website and articles on it are not investment advice or a solicitation to buy or sell any financial instruments. Each investor must make their own judgement about the appropriateness of trading a financial instrument to their own financial, fiscal and legal situation.

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