A cyclical industry refers to an industry whose revenue generation capabilities are tied to the business cycle. In other words, a cyclical industry is an industry whose performance is correlated to the business cycle.
Understanding the Business Cycle
To understand a cyclical industry, an understanding of the business cycle is required. A comprehensive overview of the business cycle can be found here. In short, a business cycle is a series of fluctuations in economic activity (generally measured by the change in the gross domestic product) over a period.
As such, cyclical industries are industries that perform well during periods of economic expansion and perform poorly during periods of economic downturn. It can be contrasted to counter-cyclical industries – industries that perform well during periods of economic downturn and poorly during periods of economic expansion.
Identifying Cyclical Industries through Consumer Purchasing Behaviors
To determine whether an industry is cyclical or not, without diving into the financial statements of a company, a key starting point would be to understand consumer purchasing behaviors. An industry is likely to be cyclical if consumers materially limit the amount of goods and services purchased from that industry during an economic downturn.
A classic example is the airline industry. Consumers tend to be more conservative and cautious about airfare spending during economic downturns (when their disposable income is generally lower).
To contrast, the pharmaceutical industry is an example of a non-cyclical industry because there is a demand for pharmaceuticals (an essential good) whether the economy is in an expansion or a downturn phase.
The following industries are commonly classified as cyclical:
Hotels, restaurants, and leisure
Textile, apparel, and luxury goods
It is also important to note that among the cyclical industries, some may be more correlated than others. The fact is illustrated in the example below.
Identifying Cyclical Industries from Financial Statements
Diving into the financial statements of a company and conducting analysis on top-line revenue are common methods for analysts to evaluate the cyclicality of an industry. All else equal, industries that experience a greater level of volatility in their revenue are likely to be more cyclical than those that show a lower level. Consider the following.
An analyst is tasked with identifying which of the two companies – Company A (who operates in Industry A) or Company B (who operates in Industry B) – operate in a more cyclical industry. The table below shows an excerpt of the year-over-year change in top-line revenues from FY 2021 to FY 2022 of Companies A and B. Assume that at the beginning of FY 2022, a recession ensued.
Considering only the year-over-year change in revenue (i.e., excluding any consideration for company size, company-specific issues, geographical exposure, etc.), which company is likely to be more cyclical?
Answer: It appears that Company B, with a year-over-year revenue deterioration of 75%, is more impacted by the business cycle than Company A.
Performance of Cyclical Industries
As outlined, cyclical industries tend to perform poorly during an economic downturn. The cause is attributed to lower levels of disposable income of consumers, who become more cautious with their spending.
Companies that operate in a cyclical industry see their performance deteriorate more significantly than companies that operate in a non-cyclical industry. It is important to note that it is not to say that non-cyclical industries witness strong performance during a period of economic downturns – the performance of non-cyclical industries are less negatively impacted during economic downturns.
For example, US companies that operated in non-cyclical industries took a hit during the 2008 Global Financial Crisis, but not to the extent of companies that operated in cyclical industries.
Provided by Societe Generale, the graph below compares the performance of the automobile sector (cyclical) and beverages sector (non-cyclical) over a 15-year period (1998-2013). Note that the automobile sector performed significantly weaker than the beverage sector during the financial crisis.
Cyclical Industries During Periods of Economic Downturn
Companies that operate in cyclical industries deal with economic downturns by reducing their cost base. It can be achieved through several methods, such as conducting employee layoffs, cutting employee bonuses, spending less on marketing and advertising, etc. For example, it is not uncommon for employees in cyclical companies to see their yearly bonuses reduced during periods of economic downturn.
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