Business Cycle Investing: Take Control Regardless of the Path

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Nobel laureate economist Paul Samuelson once said: “Economic and financial cycles inevitably come and go. The wise investor recognises these patterns and adjusts their sails to navigate the changing winds of the market.” Identifying the turning point and constructing a portfolio in harmony with prevailing macro and micro factors are challenges addressed by ‘business cycle investing.’ Stock markets exhibit distinct behaviour during growth, recession, slump, or recovery phases. With an investment framework attuned to the business cycle, you can consistently be in control, steering through any economic road.

Analogous ‘Roads’

During a downturn in the business cycle, companies adopt a cautious approach, delaying spending. Consequently, factories operate with idle capacities, businesses cut costs and capital expenditures, layoffs become commonplace, and salary freezes prevail. Consumers also curtail spending.

When the business cycle turns upward, companies gain confidence. Factories operate at full capacity, businesses expand, job opportunities multiply, salaries increase, and consumers engage in discretionary spending, including holidays.

Business cycle investing resembles navigating diverse roads. Let us see how:

1) Economic conditions in full swing equate to driving on an expressway. Good macros, a low-interest-rate environment, and robust demand mirror broad and smooth roads, ensuring a comfortable journey with less travel time and efficient fuel consumption. During such times, Banks, Infrastructure, Real Estate, and Capital Goods thrive in the market.

2) Moderate economic conditions are akin to driving on a city highway. Average roads, a less comfortable journey, and increased travel time due to traffic characterise this scenario. This aligns with average macros, a relatively high-interest-rate environment, and moderate demand. When the market is in this mode, Energy, Metals, and Technology perform well.

3) A recessionary economic zone resembles driving on a village road. Poor macros, uninspiring prospects, and low demand align with narrow roads, an uncomfortable journey, increased travel time, and high fuel consumption. In such slow-lane market scenarios, your investment portfolio is best-suited towards Technology, Pharmaceuticals, Power, and Telecom.

If the last decade favoured equities, the next decade promises to be distinctive. Investors need to be agile as the macro environment may shift. At such times, funds capable of swift theme transitions will be the winners. However, volatility is expected to be high, necessitating a portfolio capable of judiciously positioning between various themes.

Distinct Approach

Traditional investment approaches and business cycle investing fundamentally differ in several aspects. Simply put, business cycle investing relies more on the windshield mirror than the rear-view mirror.

Traditional styles depend on historical data such as long-term average PE, PB; historical returns; dividend yield track records, and flows to that category, compared to leading indicators. Conversely, business cycle investing prioritises forward signals like economic indicators, future earnings potential, market share growth, and project pipeline forecasts.

Effective application of business cycle investing assists investment managers in identifying crucial turning points. We find ourselves at a pivotal juncture in the stock markets where macroeconomic factors hold significant sway.

In the past decade, Global Central Banks, including India and the US, managed volatility by infusing liquidity through a combination of monetary and fiscal policies. Currently, interest rates are considerably lower. Any significant change in the interest rate stance may trigger a Business Cycle Phase change.

Global Central Banks have significantly expanded their balance sheets in the last decade, thereby increasing liquidity. A key alteration in the stance on quantity or a decline in stimulus may similarly trigger a Business Cycle phase change.

Business Cycle Investing

Macro factors are going to be critical for success. One of the easiest ways for a lay investor to tap into business cycle theme is by investing in funds which are based on business cycles. Mutual funds in the past few years have floated offerings with business cycle investing mandates. Such an offering will have a distinct portfolio capable of prudently positioning between various sectors. Classified as thematic funds, there are around 10 such investment products and the list is only expected to grow from hereon.

Well-run and promising options will have clearly laid out investment philosophy, investment approach, security selection, investment process, and evaluation. Such an offering typically tends to have no cap on market cap/sector/themes. When investing, investors should have an investment horizon of five years or more because macro calls do take time to play out.