13.4.4 Classifying Industries By Reaction To Economic Cycle

Classifying Industries By Reaction To The Economic Cycle

Industries can be broadly classified according to how they react to the cyclical nature of the economy. These classifications aid investors in making informed decisions based on economic conditions. The three typical classifications are cyclical, defensive, and speculative.

Cyclical Industries

Few, if any, industries are immune from the adverse effects of an overall downturn in the business cycle; thus, all industries exhibit some cyclical behavior. However, the term cyclical industry is reserved for industries where the effect on earnings is most pronounced.

Characteristics and Examples

Most cyclical industries include large international exporters of commodities such as lumber, base metals (e.g., copper and nickel), or oil. These industries are sensitive to global economic conditions, swings in the prices of international commodities markets, and changes in the level of the Canadian dollar. When business conditions improve, earnings tend to rise dramatically. In general, cyclical industries fall into three main groups:

• Commodity Basic Cyclical: Includes forest products, base metals, and chemicals.
• Industrial Cyclical: Encompasses transportation, capital goods, and basic industries (e.g., steel and building materials).
• Consumer Cyclical: Includes merchandising and automobile industries.

The energy and gold industries are also cyclical but tend to demonstrate slightly different patterns.

Economic Impact

The rate of expansion or contraction in the U.S. business cycle significantly influences the profitability of cyclical Canadian companies. Exchange rates act as an important secondary factor. Most cyclical industries benefit from a declining Canadian dollar because their exportable products become cheaper for international buyers.

Defensive Industries

Defensive industries demonstrate relatively stable returns on investor equity and tend to perform well during economic downturns. These industries are often associated with “blue-chip” companies, which maintain earnings and dividends through both prosperous periods and recessions.

Characteristics and Examples

• Blue-Chip Stocks: Shares of top investment-quality companies with a consistent record of earnings and dividends.
• Utility Companies: Gas, water, and electricity companies fall under this category. They generate consistent earnings over most economic cycles.
• Major Canadian Banks: Although considered blue-chip, bank stocks are sensitive to changes in interest rates.

Speculative Industries

All investment in common shares is speculative to some degree because of the inherent risks involved. However, speculative industries generally have unusually high levels of risk and uncertainty due to a lack of definitive information.

Characteristics and Examples

• Emerging Industries: New industries with rapidly growing companies introducing new products or services.
• Growth Companies: Companies with high multipliers on estimated earnings per share due to expected exceptional growth.

Fundamental Industry Analysis

Fundamental industry analysis is utilized to determine the intrinsic value of a stock by examining overall economic conditions, industry-specific factors, and company performance.

Key Takeaways

• Cyclical Industries: Highly sensitive to economic cycles and global economic conditions, including commodity prices and exchange rates.
• Defensive Industries: More stable in recessions, often represented by blue-chip stocks, utility companies, and banks, though they can be sensitive to interest rates.
• Speculative Industries: Carry higher risks and potential rewards, often associated with emerging industries and growth companies with less predictable outcomes.
• Fundamental Industry Analysis: Critical for evaluating stock value by considering the broader economic environment, industry trends, and individual company performance.

Frequently Asked Questions (FAQs)

What are cyclical industries?

Cyclical industries are those highly sensitive to economic cycles. Their earnings rise significantly during economic expansions and fall sharply during downturns. Examples include base metals, chemicals, transportation, and automobiles.

What defines a defensive industry?

Defensive industries are characterized by their ability to maintain relatively stable earnings and dividends through different phases of the economic cycle. These include utility companies and some banking institutions.

Why are speculative industries high-risk?

Speculative industries involve greater risk because they generally lack definitive information and exhibit higher uncertainty. Investors often look at emerging industries and growth companies in this category.

How does fundamental industry analysis help?

Fundamental industry analysis helps determine the intrinsic value of a stock by examining economic conditions, industry-specific factors, and company performance. It is essential for making informed investment decisions.

Glossary

• Cyclical Industry: An industry whose earnings are greatly affected by the economic cycle.
• Defensive Industry: An industry less affected by economic cycles, providing more stable returns through economic instability.
• Speculative Industry: An industry with high levels of risk and uncertainty, often due to a lack of definitive information.
• Blue-Chip: Shares of top investment-quality companies known for stable earnings and dividends.
• Fundamental Industry Analysis: The process of evaluating a stock by examining economic, industry, and company-specific factors.

Diagrams

    graph LR
	  A[Industries] --> B[Cyclical]
	  A --> C[Defensive]
	  A --> D[Speculative]
	
	  B --> B1[Commodity Basic Cyclical]
	  B --> B2[Industrial Cyclical]
	  B --> B3[Consumer Cyclical]
	
	  C --> C1[Blue-Chip Stocks]
	  C --> C2[Utility Companies]
	  C --> C3[Major Canadian Banks]
	
	  D --> D1[Emerging Industries]
	  D --> D2[Growth Companies]

Feel confident in your understanding of how different industries react to the economic cycle. Apply this knowledge in your evaluation of stocks and investment decisions during your Canadian Securities Course journey.