- Date : 04/02/2023
- Read: 7 mins
During the expansion and recovery phase of an economic business cycle, cyclical stocks tend to do well. Similarly, during a slowdown and recession phase, defensive stocks usually do well. A business cycle fund identifies these trends and invests accordingly.
The global economy, domestic economy, sectors, etc., go through business cycles from time to time. Usually, a business cycle consists of four phases: expansion, slowdown, recession, and recovery. A business cycle mutual fund identifies the phase in which the economy is and accordingly takes an investment decision. In this article, we will identify the various phases of a business cycle, learn what business cycle mutual funds are, and see how stocks are selected for investment.
Before we understand what business cycle mutual funds are and how they work, let us understand what is meant by a business cycle.
What is a business cycle?
A business cycle refers to the change in economic activity - either up or down. When economic activity is on the downside, it is a recession, and when it is on the upside, it is an expansion. When the recessionary phase bottoms out, there is recovery. After the recovery, the next phase of expansion starts. When the expansion phase peaks, there is a slowdown, which finally culminates in the next recession.
The above business phases keep repeating, and hence, the process is known as a business cycle. The cycle may apply to a particular sector, domestic economy, global economy, etc. The length of each phase in a business cycle may vary. The length of business cycles may also vary.
Phases of a business cycle
(Source: Tata Mutual Fund website)
The above image shows how the 4 phases of a business cycle move.
Now let us understand what happens in each of these phases. A business cycle mutual fund manager decides which stocks to invest in based on this information.
1) Recession: During a recession, an economy contracts. It means the demand is going down, companies are cutting output, profits are falling, people are losing jobs, etc.
Also Read: Should You Invest In A Recession-Hit Stock Market?
2) Recovery: To pull the economy out of a recession, the central bank cuts interest rates, and the government comes out with fiscal incentives. It leads to the economy recovering. During the recovery phase, contraction stops, and the economic output starts growing. Demand recovers, the utilisation rate of companies improves, profits start improving, and companies start hiring people.
3) Expansion: The recovery starts gathering steam. The demand starts increasing, and once the utilisation goes beyond a certain percentage, companies start investing in capacity expansion, profits and margins increase, etc.
4) Slowdown: Beyond a certain point, the expansion peaks. The demand stagnates and gradually starts going down. The profits and margins plateau and then start trending down. Inventories may start building.
What are business cycle mutual funds?
A business cycle mutual fund aims to identify sectors and, accordingly, companies in those sectors that are either at the start or in the midst of a favourable business cycle. A business cycle fund also identifies companies in specific sectors that will do well in the specific phase of a business cycle.
Benefits of investing in business cycle funds
Business cycle funds are akin to all-weather funds. The fund manager adjusts the portfolio as per the economic environment. One of the biggest benefits of investing in business cycle funds is the fund manager’s ability to assess the business phase in which the economy and the various sectors are. Accordingly, the fund manager chooses the stocks for investment.
Investment strategies
Let us further understand what is business cycle investing by looking at the investment strategy for every business phase.
1) Slowdown: Stable businesses with structural growth
Once the expansion phase of a business cycle turns and enters the slowdown phase, the fund manager can turn to shares of companies with stable business and a structural growth story. These are also known as defensives. The fund manager may also reduce exposure to mid and small-caps during the slowdown phase. During this phase, people look to cut down on all other expenses and focus on saving money for essential expenses.
Companies belonging to sectors such as FMCG, utilities, pharma, healthcare, etc., are expected to do well during the slowdown and recession phases. Some examples include HUL and ITC from the FMCG sector, NTPC and Powergrid from utilities, and Apollo Hospitals and Sun Pharma from the healthcare and pharma sector. These companies are expected to do well as they cater to the essential needs of people.
Long-term performance of FMCG companies with a stable business
(Source: https://www.icicidirect.com/mailimages/ABSL_BusinessCycle_NFO_PPT.pdf)
The above chart shows the two-decade performance of the FMCG index. FMCG companies have stable businesses with a structural growth story.
Also Read: Top 3 Best Performing Sectors In The India Stock Market: Future Prospects For 2023
2) Recession: Defensive stocks
If the economy or particular sector(s) are about to enter or are already in a recession, the fund manager can shift to large-cap stocks from defensive sectors that will emerge stronger from it. Many of these companies have existed for a long time and have been through the slowdown and recession phases before and have come out of it successfully.
As many of these companies rank among the top 3 in their respective sectors, investors prefer to hold them during the recession phase rather than mid- and small-cap companies. During these phases, the risk appetite of investors for holding mid- and small-cap companies is limited. The fund manager may either reduce or exit mid- and small-cap stocks.
3) Recovery: Cyclical stocks
Once the fund manager feels that the economy and sectors are turning the corner, they can add cyclical stocks that will benefit from the recovery. For example, companies belonging to sectors such as capital goods, industrials, metals, etc., are expected to do well during the recovery phase and the following phase, i.e., the expansion phase.
During the recession, share prices of small and mid-cap companies get beaten down. Post the recession, during the recovery phase, the sales, margins, profits, etc., start recovering. As a result, the share prices of small- and mid-cap companies usually do well as they benefit from the economic recovery.
4) Expansion: Industrial and metal stocks
When the economy advances further into expansion mode, the fund manager can add capital goods and industrial stocks. During the expansion phase, companies either expand existing facilities or build new facilities. It results in new orders for capital goods companies such as L&T, BHEL, etc. Expansion of existing facilities and building new facilities also require a lot of commodities such as steel, aluminium, cement, etc., resulting in metal companies doing well.
During the expansion phase, the small- and mid-cap companies get further re-rated due to a higher price-to-earnings (P/E) ratio.
Performance of business cycle funds
Let us look at the returns given by business cycle mutual funds.
(Source: https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/sectoralthematic.html)
Note: The above data is as of 27 January 2023. The returns are for the direct plan with a growth option. The 6-month and 1-year returns are absolute, and the 2-year returns are CAGR. The funds have been ranked based on 2-year returns. The last 3 funds in the table have not yet completed 2 years since their launch.
Should you invest in a business cycle fund?
You can follow a core and satellite investment portfolio approach for equity mutual funds. The core portfolio can be 60%-80% of your overall equity mutual funds. Within the core portfolio, you can have exposure to a mix of large-, mid-, and small-cap funds, either through active or index funds. The satellite portfolio can be the remaining 20%-40% of your overall equity funds.
The business cycle mutual fund can be a part of your satellite portfolio. Apart from that, you can include sectoral, thematic, and smart-beta funds as part of your satellite portfolio.
The global economy, domestic economy, sectors, etc., go through business cycles from time to time. Usually, a business cycle consists of four phases: expansion, slowdown, recession, and recovery. A business cycle mutual fund identifies the phase in which the economy is and accordingly takes an investment decision. In this article, we will identify the various phases of a business cycle, learn what business cycle mutual funds are, and see how stocks are selected for investment.
Before we understand what business cycle mutual funds are and how they work, let us understand what is meant by a business cycle.
What is a business cycle?
A business cycle refers to the change in economic activity - either up or down. When economic activity is on the downside, it is a recession, and when it is on the upside, it is an expansion. When the recessionary phase bottoms out, there is recovery. After the recovery, the next phase of expansion starts. When the expansion phase peaks, there is a slowdown, which finally culminates in the next recession.
The above business phases keep repeating, and hence, the process is known as a business cycle. The cycle may apply to a particular sector, domestic economy, global economy, etc. The length of each phase in a business cycle may vary. The length of business cycles may also vary.
Phases of a business cycle
(Source: Tata Mutual Fund website)
The above image shows how the 4 phases of a business cycle move.
Now let us understand what happens in each of these phases. A business cycle mutual fund manager decides which stocks to invest in based on this information.
1) Recession: During a recession, an economy contracts. It means the demand is going down, companies are cutting output, profits are falling, people are losing jobs, etc.
Also Read: Should You Invest In A Recession-Hit Stock Market?
2) Recovery: To pull the economy out of a recession, the central bank cuts interest rates, and the government comes out with fiscal incentives. It leads to the economy recovering. During the recovery phase, contraction stops, and the economic output starts growing. Demand recovers, the utilisation rate of companies improves, profits start improving, and companies start hiring people.
3) Expansion: The recovery starts gathering steam. The demand starts increasing, and once the utilisation goes beyond a certain percentage, companies start investing in capacity expansion, profits and margins increase, etc.
4) Slowdown: Beyond a certain point, the expansion peaks. The demand stagnates and gradually starts going down. The profits and margins plateau and then start trending down. Inventories may start building.
What are business cycle mutual funds?
A business cycle mutual fund aims to identify sectors and, accordingly, companies in those sectors that are either at the start or in the midst of a favourable business cycle. A business cycle fund also identifies companies in specific sectors that will do well in the specific phase of a business cycle.
Benefits of investing in business cycle funds
Business cycle funds are akin to all-weather funds. The fund manager adjusts the portfolio as per the economic environment. One of the biggest benefits of investing in business cycle funds is the fund manager’s ability to assess the business phase in which the economy and the various sectors are. Accordingly, the fund manager chooses the stocks for investment.
Investment strategies
Let us further understand what is business cycle investing by looking at the investment strategy for every business phase.
1) Slowdown: Stable businesses with structural growth
Once the expansion phase of a business cycle turns and enters the slowdown phase, the fund manager can turn to shares of companies with stable business and a structural growth story. These are also known as defensives. The fund manager may also reduce exposure to mid and small-caps during the slowdown phase. During this phase, people look to cut down on all other expenses and focus on saving money for essential expenses.
Companies belonging to sectors such as FMCG, utilities, pharma, healthcare, etc., are expected to do well during the slowdown and recession phases. Some examples include HUL and ITC from the FMCG sector, NTPC and Powergrid from utilities, and Apollo Hospitals and Sun Pharma from the healthcare and pharma sector. These companies are expected to do well as they cater to the essential needs of people.
Long-term performance of FMCG companies with a stable business
(Source: https://www.icicidirect.com/mailimages/ABSL_BusinessCycle_NFO_PPT.pdf)
The above chart shows the two-decade performance of the FMCG index. FMCG companies have stable businesses with a structural growth story.
Also Read: Top 3 Best Performing Sectors In The India Stock Market: Future Prospects For 2023
2) Recession: Defensive stocks
If the economy or particular sector(s) are about to enter or are already in a recession, the fund manager can shift to large-cap stocks from defensive sectors that will emerge stronger from it. Many of these companies have existed for a long time and have been through the slowdown and recession phases before and have come out of it successfully.
As many of these companies rank among the top 3 in their respective sectors, investors prefer to hold them during the recession phase rather than mid- and small-cap companies. During these phases, the risk appetite of investors for holding mid- and small-cap companies is limited. The fund manager may either reduce or exit mid- and small-cap stocks.
3) Recovery: Cyclical stocks
Once the fund manager feels that the economy and sectors are turning the corner, they can add cyclical stocks that will benefit from the recovery. For example, companies belonging to sectors such as capital goods, industrials, metals, etc., are expected to do well during the recovery phase and the following phase, i.e., the expansion phase.
During the recession, share prices of small and mid-cap companies get beaten down. Post the recession, during the recovery phase, the sales, margins, profits, etc., start recovering. As a result, the share prices of small- and mid-cap companies usually do well as they benefit from the economic recovery.
4) Expansion: Industrial and metal stocks
When the economy advances further into expansion mode, the fund manager can add capital goods and industrial stocks. During the expansion phase, companies either expand existing facilities or build new facilities. It results in new orders for capital goods companies such as L&T, BHEL, etc. Expansion of existing facilities and building new facilities also require a lot of commodities such as steel, aluminium, cement, etc., resulting in metal companies doing well.
During the expansion phase, the small- and mid-cap companies get further re-rated due to a higher price-to-earnings (P/E) ratio.
Performance of business cycle funds
Let us look at the returns given by business cycle mutual funds.
(Source: https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/sectoralthematic.html)
Note: The above data is as of 27 January 2023. The returns are for the direct plan with a growth option. The 6-month and 1-year returns are absolute, and the 2-year returns are CAGR. The funds have been ranked based on 2-year returns. The last 3 funds in the table have not yet completed 2 years since their launch.
Should you invest in a business cycle fund?
You can follow a core and satellite investment portfolio approach for equity mutual funds. The core portfolio can be 60%-80% of your overall equity mutual funds. Within the core portfolio, you can have exposure to a mix of large-, mid-, and small-cap funds, either through active or index funds. The satellite portfolio can be the remaining 20%-40% of your overall equity funds.
The business cycle mutual fund can be a part of your satellite portfolio. Apart from that, you can include sectoral, thematic, and smart-beta funds as part of your satellite portfolio.
