Andrew Page
Andrew Page

There has been a noticeable shift in market rhetoric of late, with terms such as ‘Great Recession’ losing favour to phrases such as ‘green shoots’. And certainly there is some justification for this. After all, growth forecasts have been revised upwards for most economies, corporate results have come in above expectations and share markets have rallied strongly from their bear market lows. The real question of course is whether or not the worst is now over.

It seems as though many in the market are increasingly convinced that this is the case; the evidence for this has been the noticeable shift from defensives back into cyclical stocks. Before we explore this observation in greater detail, let’s take the time to understand what is meant by ‘defensive’ and ‘cyclical’.

Defensive stocks are those that are involved in industries that enjoy rather steady demand for their goods and services throughout the business cycle. Consumer staples, utilities and healthcare are all examples as consumers require their services regardless of how well the economy is doing. The downside is that when the economy is doing really well, these types of companies don’t tend to benefit as much as other stocks; again because the demand for their services is relatively constant.

This can be seen in the following chart, which tracks the relative performance of 3 defensive stocks between the high of November 2007 and the low of March 2009.

click chart for more detail
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Contrast this with cyclical stocks that are more directly impacted by the state of the economy. Airlines, consumer discretionary and construction related industries are all examples as the demand for their goods and services usually drop sharply when the economy goes downhill.

A long standing, and usually very beneficial strategy is for investors to switch into defensive stocks when things start to get tough, as this better protects investment capital. Investors then switch back into cyclical when the future starts to look a little brighter so that they can benefit from the expected recovery in sales, earnings and ultimately share price. Usually, the gains made by cyclical stocks in the early stages of a recovery are well above the market average. The key to this approach of course is to correctly anticipate the transition between the periods of expansion and contraction.

click chart for more detail
click to enlarge

Stocks related to housing and construction certainly qualify as cyclical. Indeed, given this sectors’ generally high reliance on debt, the credit crisis savaged it more than most. The ensuing economic slowdown has meant that many construction firms have had to contend with both falling demand and difficult credit conditions and as a result we saw some spectacular falls. Between the top and bottom of the market, that is between November 2007 and March 2009, the ASX200 dropped by approximately 50%. If you look at stocks related to the building and construction industry, the average fall was 71%.

Table 1. Percentage change in share price between November 2007 and March 2009

Company Industry Subgroup Change
Ausenco Limited Construction & Engineering – 20103010 -87%
AJ Lucas Group Construction & Engineering – 20103010 -22%
Austin Engineering Construction & Engineering – 20103010 -64%
AVJennings Limited Homebuilding - 25201030 -83%
Boart Longyear Construction & Engineering – 20103010 -97%
Cardno Limited Construction & Engineering – 20103010 -61%
Clough Limited Construction & Engineering – 20103010 -38%
Crane Group Limited Building Products - 20102010 -58%
CSR Limited Industrial Conglomerates - 20105010 -71%
Fisher & Paykel App. Household Appliances - 25201040 -86%
GRD Limited Construction & Engineering – 20103010 -91%
G.U.D. Holdings Household Appliances - 25201040 -51%
GWA International Building Products - 20102010 -49%
Hills Industries Ltd Building Products - 20102010 -76%
Hastie Group Limited Building Products - 20102010 -75%
Leighton Holdings Construction & Engineering – 20103010 -71%
Lycopodium Limited Construction & Engineering – 20103010 -69%
Macmahon Holdings Construction & Engineering – 20103010 -82%
Monadelphous Group Construction & Engineering – 20103010 -61%
Nomad Building Building Products - 20102010 -91%
NRW Holdings Limited Construction & Engineering – 20103010 -92%
Quantum Energy. Household Appliances - 25201040 19%
RCR Tomlinson Construction & Engineering – 20103010 -86%
Sedgman Limited Construction & Engineering – 20103010 -86%
Service Stream Construction & Engineering – 20103010 -84%
Swick Mining Construction & Engineering – 20103010 -89%
Sth Crs Elect Engnr Construction & Engineering – 20103010 -66%
United Group.Limited Construction & Engineering – 20103010 -68%
VDM Group Limited Construction & Engineering – 20103010 -94%
WDS Limited Construction & Engineering – 20103010 -71%
Watpac Limited Construction & Engineering – 20103010 -85%

While it is true that these stocks well and truly underperformed the market during the pull back, the fact is they have significantly outperformed during this most recent rally. Indeed, between March and August 2009, the stocks listed above saw an average advance of 128% - over three times the advance we saw from the ASX 200. The best was Boart Longyear with a gain of over 537%, although more than half of these stocks saw their share price more than double over this period.

This is partly due to the fact that many of these stocks were significantly oversold back in March, when broader concerns over the economic outlook outweighed specific company fundamentals. Once the future seemed to clarify somewhat and dire predictions failed to come to pass, there was a dramatic revaluation across the sector. So it is important to remember that while recent gains have been outstanding, they were made off an extremely low base. There is also a bit of a mathematical trick that makes upside movements seem more attractive. For example, if a stock falls from $1 to 50c, it represents a 50% decline. For the stock to return to $1 it needs to experience a 100% gain.

Nevertheless, an investment in these stocks in recent months has so far proven to be an excellent move. The $64 million question of course is whether or not these gains will continue. I’m not going to pretend that I have the faintest idea of what the short term holds for the market, but for the patient investor I believe that many attractive prospects abound.

As brutal as things have been over the past couple of years, the credit crisis and economic slowdown has forced most businesses related to building and construction to strengthen their balance sheets; either through shedding non-core assets and/or raising capital through share issues. This means that many of these companies are positioned well to take advantage of any recovery. They are leaner, meaner and more focused than they were previously.

As for the recovery, most will agree that it’s a question of ‘when’ rather than ‘if’. This means that although some risks remain, those with a long term view, who can afford to ride out any volatility, are likely to benefit from switching back into building and construction related companies. Of course, one should never focus entirely in one sector alone, but an overweighting across a well balanced portfolio is likely to be advantageous.

Given the relatively sound outlook for the local economy, it is probably advisable to concentrate on stocks with a domestic focus. This is especially true when you consider the shortfall in residential housing and projections for demand to continue to outstrip supply.

Lastly, although a cyclical focus is easier to justify at this juncture, we must be realistic in our expectations. Although many stocks have seen gains well in excess of 100% in recent months, it is important to remember that these are particularly rare events, and it is virtually impossible for this kind of growth to continue over a prolonged period. So while portfolios with a cyclical bias are likely to outperform during a recovery, the degree of outperformance is most likely to be more moderate than the recent experience.

As always, the important thing for investors to focus on is where these stocks are likely to be at the end of your own investment time frame. If you can only afford to invest for 12 months or less, it is difficult to be confident about any particular focus. However, those with the ability (and patience) to allow investments to mature over several years are likely to do well with a cyclical focus, and certainly one that involves exposure to the building & construction industry.

Make the markets work for you

Andrew Page