Why we favor cyclical and value stocks

Apr 13, 2021
  • Michael Gates, CFA

There’s a saying in markets which I’ll both butcher and paraphrase – that you can make a lot of money in stocks when the economy simply improves from a ‘total disaster’ to ‘not so bad’.

The evidence to support this is both common sense and consistent. During downturns the drop off in demand is sudden and steep, whereas the supply line is only temporarily taken offline. This ‘mothballed’ capacity becomes spare before it is cut altogether, and that often depends on how long the downturn lasts.

When demand starts to return the capacity comes back online. However, public companies need to safeguard their earnings for shareholders during that bad period, cost cutting is a way they can achieve that goal. Variable costs (those that scale with output) are easier to cut in the short run, while fixed costs (like a manufacturing plant) are much harder to quickly increase or decrease.

This means that when activity starts to pick up again, the cost cutting has left the firm with fatter margins and geared towards the new level of activity as well. Meaning, a faster recovery can often translate to a stronger turnaround in earnings.

Belt tightening today, fatter margins in the future

S&P 500 Operating Margin vs. NBER Recession indicator

S&P 500 Operating Margin vs. NBER Recession indicator

Source: S&P500 Operating Margin vs. NBER Recession indicator

In and of itself this is a powerful and simple driver of stock prices coming out of a recession. There is another dynamic that we believe can add to this upsurge, and it comes from how the analyst community covering stocks processes this change in the environment.

A part of analyst’s job is to estimate how company earnings will take shape and then revise as new information becomes available. In normal economic times, analysts tend to be consistently over-optimistic regarding the earnings of the companies they cover. During periods of economic recovery, things are different. Analysts tend to have to “catch up” with the direction of earnings improvements, to revise their estimates to capture the magnitude of the uptick, and then also try and forecast how long this earnings improvement can last. Slow and steady growth is easier to model than a sudden and sharply changing economy. All of this is without mentioning how complicated the pandemic has made this task!

In our model portfolios, I’ve been reflecting on this opportunity in stocks with the addition of value stocks, cyclical sectors and small-cap equities. These types of companies have more of the cost structure rigidity and sensitivity to upticks in activity, which can really benefit them in times like these. Thanks to that catch up occurring in the analyst community, I can keep focused on when to start reining in the trade.

Lastly some good news; stocks can also make you money when the economy improves from ‘not so bad’ to ‘pretty, pretty, pretty good’ too!

Michael Gates, CFA, Head of Model Portfolio Solutions for Multi-Asset Strategies & Solutions
Michael Gates, CFA, is the lead portfolio manager for Target Allocation Models in the Americas.
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