In volatile times, what are the best ways to invest? Truth be told, there are numerous strategies portfolio managers try to employ, each with its own merits.

Today, we will, however, turn our attention to the top-down strategy which focuses mainly on investing in cyclical or defensive stocks.

Cyclical stocks are defined as stocks that have a high correlation with the cycle of a particular economy. When the economy is contracting, the profits from a cyclical company tend to fall and the stock prices follow suit. Conversely, when the economy is expanding, stock prices from the same company will increase as the profits do.

For clarity, take, for example, the information technology industry. A consumer would be more willing to purchase a new laptop when he/she has an increase in disposable income, which would lead to higher revenues for that industry. The opposite would happen if their income declined. Examples of cyclical stocks would be Delta Airlines, Visa, and Nike.

Defensive stocks are stocks with very low correlation between their price and the cycles of an economy. Whether the economy is contracting or expanding, the profits of these companies remain constant and so does the share price.

Take, for example, a company in the health-care industry or alcohol industry. Consumers will always be in need of medication whether times are good or bad, and consumers will purchase alcohol no matter the economic cycle. They may even purchase more alcohol when times are bad. Examples of a defensive stock would be Johnson & Johnson, Diageo, etc.

The savvy investor will try to employ the top-down approach, which is integrating the knowledge of cyclical and defensive stocks into this investment decision.

How do we classify a cyclical or defensive stock?

On face value, this may seem very simple; however, some stocks exhibit both defensive and cyclical behaviour throughout their lifetime. Let’s delve a bit further into this notion. The utility industry has always been considered as being defensive; however, the strength of a utility company is now being closely linked to the strength of the country in which it is situated, especially since the economic crisis in 2008.

The dilemma also presents itself in sub industries; for example, the clothing and luxury good industry. These industries were once considered cyclical but are now considered defensive because of the ability of some large companies to keep revenues constant, even in hard times.

Which is more expensive?

Defensive stocks have historically been more expensive; however, this does not hold true in all scenarios. Let us discuss two measures that determine the valuation of these stocks.

First, Beta is a statistical measure of the elasticity or sensitivity of a stock in relation to the market. Defensive stocks usually have a lower Beta, less than 1. They are usually more resistant to market volatility, whereas the Beta for cyclical stocks are usually higher because they are usually less resistant to market volatility.

Second, the price earnings ratio, more commonly known as P/E, compares the price of a share to its earnings per share (EPS). For example, if the P/E for a particular stock is 10, it simply means the investor is paying 10 times of earnings per share to purchase the stock. This statistical measure usually determines the stock valuation and the price of the stock.

As discussed before, defensive companies are able to generate stable revenues regardless of the market volatility, which then transcends into EPS and share price. This is why defensive stocks are able to trade at higher prices than cyclical stocks generally. The common notion is, you should pay a premium for a company that is deemed to be less risky.

Conclusion

The ability to take advantage of economic cycles using the top-down approach is a tool every investor aspires to have. Having an understanding of cyclicality can boost your investment portfolio exponentially. However, one should always be mindful of the fact of that a defensive company may not always have stable revenues throughout its lifetime.

The best way to approach this is to combine both strategies to have a fruitful investment portfolio.

— Rashidi Thomas is a wealth manager at Stocks & Securities Ltd