Cyclical Vs Defensive Stocks

There are more than 6000 companies listed on the Indian Stock Market. These listed companies are of different sizes; large-cap, mid-cap, small-cap, and micro-companies. These companies cater to different industries. Investors, especially those new to the market, may have difficulty picking out stocks. Investors build a portfolio with a goal in mind. Investors try picking the best stocks after considering different metrics like the company’s sales growth and PE ratio. 

However, it is essential to pick good stocks and pick the right stocks to achieve the set goal. It means that, along with considering factors like valuation and sales growth, one should also examine the nature of the stock. One needs to pick stocks that will benefit the best from the macroeconomic trends. Cyclical stocks and defensive stocks are two categories of common equities with distinct characteristics.

You must know what cyclical stocks and Defensive stocks are in detail to understand cyclical stocks vs. defensive stocks clearly. 

Cyclical Stocks

Cyclical Stocks are very receptive to changes like the economy. The stock price of such stocks shows conspicuous cyclical patterns. It is because the underlying business of such stocks is very dependent on the economic conditions, trends, and policies.  

These stocks tend to perform very well during an economic boom and give investors high returns. On the other hand, cyclical stocks plummet during a period of recession or economic degrowth. The stock price of such stocks does not go significantly up again until there are signs of good economic growth. Due to such aggressive price movements, cyclical stocks are very volatile. One needs to be cautious while picking these stocks since they are high-risk, high-reward stocks.  

For example, the government develops policies to boost the infrastructure during an economic boom. Then infrastructure, building materials, and steel stocks tend to perform well. Similarly, people have more disposable income when the unemployment rate is under control and high employment levels. Automobile, real estate, and durable consumer stocks do well in this scenario. 

Whereas if there is an economic recession or high inflation levels, people avoid purchasing houses, automobiles, and consumer durable goods. Infrastructure projects stagnate. The demand for steel and building materials paused for a long time. In this case, stocks belonging to the above sectors show a steep decline. 

Defensive Stocks

On the other hand, Defensive stocks rarely show considerable fluctuations in their stock price. Unlike cyclical stocks, the stock price of defensive stocks does not shoot up quickly. Neither does the stock price crash. It is because defensive stocks generally belong to businesses or industries with consistent cash flows. In simple terms, such companies generate stable revenues and profits almost all of the time. 

Macroeconomic changes barely affect the performance of the underlying business. These stocks generally grow at a slow rate if the profits are better than the previous quarter’s profits.

The stock price may show a slight accretion upwards during an economic boom. During a recession, there might be a slight dip in the stock price, or the stock price may go through a phase of consolidation. For instance, a company that manufactures basic eatables or toiletries will continue manufacturing and selling products during economic growth or recession. Since their products are essential, people will not stop buying them. Hence the stock price of these companies is less volatile. Defensive stocks are low-risk and low-reward stocks. 

Identifying the Pattern

One can get a general idea of the nature of the stock just by looking at the stock’s price chart; for that, one can simply zoom out and look at the all-time performance of the stock price on the chart. If the stock price shows a cyclical pattern after sporadic intervals, the stock is likely to be cyclical. Whereas if the stock price over time looks more or less similar to a linear slope, it is likely a defensive stock. 

Benefits of Cyclical and Defensive Stocks

Cyclical stocks are riskier stocks but can generate enormous returns during favorable conditions. They are likely to do exceptionally well in an environment that promotes high economic growth. Factors like growth-driven policies, high employment rates, and an economy with healthy controlled inflation can benefit cyclical stocks. During such conditions, cyclic stocks can outperform the market significantly. 

Defensive stocks are less risky and generally generate stable returns in most environments. Even when several negative factors play out in the economy, these stocks do not hit rock bottom. However, returns generated by these stocks are considerably less than that of a cyclical stock in a booming economy. The defensive stock will perform in line with the broad market. 

Cyclical Stocks vs. Defensive Stocks: Which One is Better?

Both cyclical and defensive stocks have critical differences that give each their pros and cons. New investors often get caught between the argument of cyclical vs. defensive stocks. Cyclical stocks help exponentially grow one’s capital, while defensive stocks help preserve one’s capital. 

Diversification of one’s portfolio is the key to success in the stock market. One should have stocks of different companies, from different sectors, of different natures. Having both cyclical and defensive stocks is a logical move. During an economic boom, the stock price of the cyclical stocks in the portfolio will run-up. Whereas if there is a sudden economic downturn, defensive stocks will help save one’s portfolio from crashing. 

Conclusion

This article on “Cyclical vs. Defensive stocks” helps you to understand the difference between cyclical vs. defensive stocks. You could allocate cyclical and defensive stocks in your portfolio according to your risk appetite. Staying up-to-date with the current happening; keeping track of the macroeconomic trends, government policies, and industry news can help you decide the allocation of cyclical stocks compared to defensive stocks. However, you need to keep in mind that along with the nature of the stock, you must take all the stock fundamentals into account while picking stocks.

Conducting a holistic business analysis is the best way to evaluate the company. You need to study the company’s business, understand the industry, and compare it with the competition. In a phase of economic growth, a cyclical stock with good fundamentals will consistently outperform one with poor fundamentals. 

Likewise, a solid defensive stock will have higher chances of holding up than a weak one during a recession. I hope you found this article helpful in clearly understanding cyclical stocks vs. defensive stocks.