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MC Learn Fundamental Investing | Business cycles and their roles in investment decisions

Understanding the effects of business cycles on the market is essential to identifying a good investment.

July 14, 2022 / 05:20 PM IST
Representative image.

Representative image.

Module 1: Chapter 5.

In economic theory, the terms economic cycle and business cycle are used interchangeably. But if you look closely, these can differ at times. Different sectors go through their own cycles, which may be different from the economic cycle. Understanding the effects of business cycles on the market is essential to identifying a good investment.

What is a business cycle?

Just like the economy, a business cycle is the ups and downs that a particular business or sectors go through naturally over a period. Much like the economy, they may have each of the four phases: expansion, peak, contraction and trough. However, unlike the economy, an individual sector business, or sometimes, even an entire sector, may go into a permanent decline and may never recover for reasons we will discuss below.

Factors affecting the business cycle

Economic cycle: The first factor affecting a business cycle is the broad trend in the economy. As the saying goes, a rising tide lifts all boats. A general rise in economic activity will generally help most businesses and sectors.

Cyclicality: Besides the economic cycles, individual sectors go through their own cycles for reasons similar to the economic cycle. For instance, consider real estate. The cycle begins when property prices are unusually low which starts attracting demand for buyers. The demand for property causes prices to rise upward, attracting more investments in the sector and more development. Many early property are now sitting on profits, attracting more investors to the sectors, which causes a virtuous cycle. At some point, however, there has been so much supply of new property that it outstrips supply. This may cause prices to first stagnate and then turn lower. The virtuous cycle now turns into a vicious cycle causing buyers to turn into sellers, causing prices to fall more and so on.

Government policies: Often, government policies (or lack thereof) can make or mar the prospects of entire sectors. In India, the telecom sector saw a big boom between 2003 and 2010 when falling calling and data prices caused a big boom in penetration and expansion of the market.

However, the government priced spectrum at an enormous rate in the allocation process, which invited judicial scrutiny for its opacity, causing several companies to go belly up.

Technology: Increasingly, technology has been disrupting nearly all sectors, from transportation to retail to autos. This means that new companies that are more technologically advanced have a chance at taking market share from those that fail to make the leap.

For instance, in the US, Tesla today is valued more than nearly all the auto companies put in the world put together, despite having only a fraction of the sales or manufacturing capacity. The reason for this is that the company has taken a big lead in making of electric vehicles, which are a cut above the competition when it comes to software features.

Whether Tesla’s valuation is justified remains to be seen but the fact is the company’s technological disruption has forced companies to ramp up their EV plans, and those that fail to make the leap may be left by the wayside in the electric future.

Other factors: Factors such as a shift in consumer preferences or even company-level changes, such as change in management, could businesses or sectors to go through ups and downs, or even a long-term growth phase or permanent decline.

Business cycles and the market

Investors who can understand and even to a degree predict changes in the business cycle can greatly benefit.

The reason for this is that stock prices overreact in response to the changes in the business cycle. When a business is undergoing a downturn, the stock price can fall sharper than the decline in earnings. This is because investors don’t value such companies very much, causing them to trade cheaply.

On the other hand, companies or sectors that are seeing an upward turn in their fortunes will see not only their earnings rise but the rise in stock prices even more, due to the phenomenon called rerating. Rerating simply means a company that generates Rs 100 crore profit but whose profit is expected to remain at the same level will be valued at x times its profits. But another company whose profit is Rs 100 crore, but which is expected to double its profit next year may trade at 2x or 3x times the first company.

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first published: Jul 14, 2022 05:18 pm