A cyclical company is likely to experience wider-than-average fluctuations in demand, high demand in economic expansion and low demand in economic contraction, and may be subject to greater-than-average profit variability related to high operating leverage. Non-cyclical companies produce goods or services for which demand remains relatively stable throughout the business cycle.
Uses of Company Descriptors
Describing a company as defensive or cyclical allows the investor to gain a basic understanding of how the company is expected to perform in various circumstances. The stock of a cyclical company will likely be more volatile than the stock of a non-cyclical company so these definitions may help the investor in portfolio construction. These descriptions may also help to put historical performance into perspective as the strong performance of a cyclical business during a five-year economic boom may have little to do with how the company might perform in a recession.
Separating stocks into value or growth buckets doesn’t always seem intuitive, but it can be useful in understanding the investment approach of an actively managed fund. For example, an investor should take notice if an actively managed fund in their portfolio advertises that it aims to outperform its benchmark through investing in deep-value stocks, but has mostly invested in stocks statistically classified as growth.
Limitations of Company Descriptors
One limitation of the cyclical/non-cyclical classification is that business-cycle sensitivity is a continuous spectrum rather than an “either/or” issue, so placement of companies into one of the two major groups is somewhat arbitrary. Another limitation is that different countries and regions of the world frequently progress through the various stages of the business cycle at different times.
Groupings by statistical similarities also tend to be somewhat arbitrary, and the composition of groups may vary significantly across time periods and world regions. Also, there is no guarantee that past correlation values will continue in the future. Finally, all statistical methods are at risk of falsely finding relationships that don’t actually exist or of excluding a relationship that actually is significant.
Which of the following is least likely a common use of company descriptors?
A. Determining stocks that will perform similarly in the future
B. Determining which companies may experience a significant decline in earnings in the event of a recession
C. Understanding a fund manager’s general investment approach
The correct answer is A.
While statistical analysis groups companies based on past performance similarities, it is not very useful in determining future performance.
Option B is incorrect. The business-cycle sensitivities classification is likely to help an investor develop an idea of which companies are more protected from recessions and which companies are not.
Option C is incorrect. A statistical similarities grouping is likely to help an investor break down a fund manager’s holdings to understand their general approach.
Reading 40 LOS 40c:
Explain the factors that affect the sensitivity of a company to the business cycle and the uses and the limitations of industry and company descriptors such as “growth,” “defensive,” and “cyclical”