05 December 2011

Cyclical Stock VS Defensive Stock

Today I would like to share with you more on the concept of investing in cyclical stock vs defensive stock.

Defensive stocks means that the share performance is not impacted much by the macro-economy environment as their revenue actually not really affected by the market. For example, people still need to eat when the market is in the downturn. Normally defensive stock fulfill some of the criteria:

  • The revenue and earning growth is growing even if the market is not performing well. 
  • Cash Cow Company - Those companies normally is having a lot of cash flows since they do not require high CAPEX (Capital Expenditure to purchase a lot of Fixed Asset)
  • High Current Asset Ratio - As they do not require a lot of debt to grow their business, hence they do not really go for low Current Asset Ratio. 
  • High Interest Coverage Ratio - As they do not borrow much money from bank, hence they also do not need to pay more to bank for loan. 
Cyclical stock normally react more than what market reacts when the market turns better or worse. Normally you can see some patterns there: 
  • High Debt to Asset Ratio - Normally those company will borrow a lot of money when the time is good and prevent it from having cash flow problem when the market turns worse. 
  • Inconsistent Growth in Revenue and Earning as well as Cash Flow - As the cyclical stock will face difficulty during downturn and enjoy a very fantastic growth when the market turns better, hence it is showing inconsistent growth in revenue and earnings. 
  • Normally you will see some industry is experiencing this - for example Coal / Iron / Palm Oil / Exports / Construction etc. They require a lot of cash flow to strive through. 

Different investors will have different required return and risk appetite. If your risk appetite is low (for example, if you do not like to experience 50% losses in a year), then my advice to you is to avoid those cyclical stocks. If you are OK to experience 50% temporary loses, then you may go for the cyclical stocks. Be make sure that you fully understand that industry and also the company's management's ability in fighting through the hard time (at least not having problem on cash flows).  

You can drop me an email to share about your views on my opinions on this topic. Have a nice day. :)

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