Long-term investors, value investors and bottom-up approaches rarely rely on timing business cycles, but many active investors can realize value by adjusting their portfolios as cycles progress. Tracking revenue growth and profit margins can help investors identify the present state of the overall economy, and successful active investors manage sector exposure based on these observations. The most important financial ratios for analysis vary depending on the sector in question, but the focus generally moves from growth potential to valuation to financial health as the cycle progresses.
The early stages of the business cycle are marked by renewed optimism and rising growth expectations. Businesses begin investing more heavily in growth, while consumers become more willing to purchase non-essentials. Productive stocks high up the value chain see rapid increases in demand, and lean inventories lead to strong demand and wide margins.
Investors exhibit increased appetite for risk, moving into more speculative stocks. The technology and industrial sectors generally exhibit superior performance during the early part of the business cycle, and stock market cycles tend to lead businesses cycles. Many technology companies are unprofitable and have high growth expectations, so popular valuation ratios such as price-to-earnings (P/E) and price-to-book (P/B) are not applicable. Instead, growth companies are often evaluated based on revenue growth, market share and the price-to-sales (P/S) ratio. Customer acquisition costs and research and development (R&D) as a percentage of revenue are also important metrics in industries such as software or internet information services. Industrials are generally very different from technology firms and are more often analyzed with the earnings-before-interest-and-taxes (EBIT) margin, return on invested capital, and efficiency ratios, such as inventory turnover.
The mid-cycle phase is characterized by a moderation of growth rates and broader economic stability, and the economy is still in expansion mode during this phase. Strong performance is shared across different industries and sectors, with the bullish signals from the early cycle trickling down the supply chain. Sustained improvements to employment and wages extend the strong performance to non-essential goods, and more mature technology companies that rely on strong capital expenditures also benefit.
The information technology sector has been the strongest historical performer in the mid-cycle phase, with consumer staples, utilities and materials lagging. However, the divergence among sector performance in the mid-cycle is the lowest of all phases. This makes P/E, PEG ratio, P/B, gross margin and price-to-cash-flow important, with more mature businesses performing well across more sectors.
The late-cycle phase is characterized by the deceleration of growth that precedes contraction. Inventories tend to grow, corporate profit margins fall and interest rates grow high. Inflation also reaches relatively high levels due to tight labor markets and high capacity utilization. Equity valuations are usually relatively expensive, leading to modest annualized returns.
Inflation helps drive superior results for energy and materials sectors, the profitability levels of which are dictated by commodity prices in the short term. Utilities, telecommunications and consumer staples stocks gain the attention of forward-looking investors, who begin moving toward less cyclically sensitive sectors and strong dividends. Lean years require strong financial health, so interest rate coverage, debt-to-capital and the current ratio gain added importance. Dividend yield also becomes more important as growth stock demand wanes.
The recession phase is marked by economic contraction, during which time unemployment rises, consumer sentiment falters and business investment declines. Demand for goods and services tumbles, especially among non-essentials. Monetary policy usually leads to lower interest rates, which stimulate business activity and are expected to induce recovery.
Investors leave the equity market for lower-risk asset classes, and equity investors tend to favor more defensive sectors. The consumer staples sector has a strong historical record of outperforming other sectors, while utilities, health care and telecommunications are also generally stronger than industrials or information technology. Investors should monitor leverage and liquidity ratios to confirm financial health, and ratios such as same-store sales, organic revenue growth and gross margin are good indicators of recovery as the next cycle begins.