A business cycle approach to investing

This is an overview of my business cycle approach to investing, and the equity income opportunities on offer.

Divide and conquer

We take a business cycle approach to investing and divide stocks into seven style groupings, according to their correlation with the business cycle. The style groupings range from areas of the market with a positive correlation to the cycle (Commodity Cyclicals, Consumer Cyclicals and Industrial Cyclicals) through to Growth and Financials, and then the negatively correlated areas which are Growth Defensives and Value Defensives. Each area performs differently according to which phase of the business cycle we are in (recovery, expansion, slowdown and recession). We seek to allocate capital so that it has the appropriate weighting to each grouping as we move through the cycle.

As income investors, there is a second aspect to our approach. We divide the stockmarket into four different dividend style groupings – cyclical yield, stable yield, high yield and growth yield. These dividend style groupings allow us to see how the fund is positioned in terms of where we are getting the income from.

Yield opportunities throughout the cycle
One common misconception about income investors is that we invest most of our capital in companies that offer the highest dividend yields. That certainly isn’t the case for us. We aim to deliver returns across the cycle and invest in firms that offer both capital growth and income.

At the start of the business cycle (recovery phase) we invest in stocks that fall into our cyclical yield dividend style grouping. These firms are highly sensitive to the economic cycle, growing profits and share prices (by extension dividends) as the macroeconomic backdrop improves. They may pay low or even no dividends at the point when we invest in them, but we make our investment with the expectation that dividend payments are likely to grow over time.
)Business cycle
As the cycle moves to expansion phase we continue to invest in these firms but also move into growth stocks, which usually perform well as the recovery gains greater traction. When the cycle peaks and moves into the slowdown phase, we would reduce exposure to cyclical yield stocks as these suffer from a weaker economic backdrop. We also add exposure to stable yield stocks, which are less affected by changes in the economic environment.

As the cycle moves into recession, we turn to high yield and stable yield stocks. These kinds of firms – food groups or pharmaceuticals for example – are what we term defensives. Many such firms offer little in the way of capital appreciation. However, in a recessionary environment our focus is less on growing capital than on protecting what we already have. As a result, firms that offer high dividend yields, and resilient share prices, are typically where we allocate most of our portfolio at the end of the cycle.

Current scenario offers opportunities in cyclicals
One feature of the current cycle is the sheer length of time it has taken for Europe to emerge from crisis (Lehman crisis followed by the eurozone crisis). What this means is that profits are currently at extremely depressed levels, but have high potential for recovery and therefore high potential for dividends to rise as well.

MSCI chart

With the macroeconomic backdrop starting to improve in Europe, we take the view that now is the time to favour cyclical, economically-sensitive stocks. These kinds of firms are generally trading on relatively cheap valuations and can have substantial scope for profit improvements.

Sectors and securities mentioned are for illustrative purposes only and not to be viewed as a recommendation to buy or sell.

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