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Picking Stocks Throughout The Business Cycle
Education | 08 August 2014
Related stocks:
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By: Shane Goh
Articles (99) Profile

As of 1 August, 775 firms are traded on the Singapore Exchange (SGX), dwarfed by approximately 2,800 companies listed on the New York Stock Exchange and about 3,100 counters sitting on the Nasdaq.

Even with a relatively smaller number compared to its counterparts, most investors would only remember the household names such as DBS Group Holdings and CapitaLand as well as certain smaller firms that they follow fervently on the SGX.

If we were to remove the Straits Times Index and FTSE Mid-Cap Index’s components stocks, that would leave us with 695 firms. How many can you name?

While we know that multi-bagger investments may be found in the small-cap space, picking out a gem from several hundred companies appear to be a daunting task.

In a recent seminar held by CFA Singapore and PhillipCapital, Shares Investment walked away with a systematic approach to make the filtering process more manageable.

Understanding The Business Cycle
In economics, there’s a concept called the business cycle. A business cycle is the fluctuations in economic activities that an economy experience over a period of time, namely, expansion or recession. The top of the business cycle is known as a peak, while the bottom is called a trough.

Pring Turner Business Cycle

Source: www.pringturner.com

In simple terms, the length of one business cycle is determined by the duration it takes the economy to go from one peak to the next, or one trough to the next.

According to the US National Bureau of Economic Research, there have been 11 business cycles since 1945 to 2009, with the average duration of a cycle slightly less than six years. During this period, the average expansion lasted 58.4 months while the mean contraction is over in 11.1 months.

In each business cycle, there are six stages. Based on Pring Turner’s graph, stages one and two depict a recession followed by a bottoming out. Stages three and four show the recovery and expansion phase of an economy, before hitting a peak at stage five and finally, displaying the early part of a downturn in stage six.

Sector Rotation
As an investor, understanding which business cycle the economy is in can help to narrow down the sectors that stand to benefit from changes in consumer tastebuds.

Throughout a business cycle, various sectors tend to flourish at different stages. During a recession, consumers cut back on luxury spending while businesses contract. As a result, basic necessities providers such as utilities and food companies fare better in such times as people continue consuming these products.

Conversely, in an expansionary phase, consumers are more bullish on future prospects and increase their expenditure. This improves global trade and bodes well for companies that rely on discretionary spending such as oil, property and shipping players.

Apply Stock Filters
After we have identified the industry we wish to focus on, a simple stock screener can be applied to sieve out stocks that meet or surpass our criteria. The common filters used, measure a firm’s historical growth, profitability, leverage and relative valuations.

All things being constant, we tend to favour companies that have exhibited stronger revenue and net profit growth in the past few years and delivered a higher return-on-equity, or possess premium gross profit and net profit margins compared to its competitors.

Intuitively, a lower-leveraged firm, commonly measured by net-debt-to-equity, would be better positioned to weather a storm should a crisis hit while a firm that is currently traded at lower price-to-earnings ratio and –price-to-book-value suggests that the company is “cheaper” in comparison to its peers.

Company Specific
By comparing firms within the each sector among themselves, one or more firms would tend to stand out. Sometimes it could be due to higher growth rates than its peers, while at other times, profitability could be the differentiator.

However, an investor must always question the merits behind the disparity. Firstly, one needs to understand the basic fundamentals behind the firm and how it generates its turnover. In the case of a manufacturer, we should find out who the end consumers are and what the demand outlook is.

Next, is the growth in revenue a one-off incident or a sustainable recurrence? Are the premium margins enjoyed by the company due to some patent or technical know-how which its competitors are unable to replicate?

These are important factors to consider as you wouldn’t want to chase after a one-trick pony but rather, sink your cash into a firm that possesses a wide economic moat.

Economic moat, a term coined and popularised by Warren Buffett, is defined as a competitive advantage which one company has over its peers in the same industry. A strong and well-known brand name, pricing power and large market share are some examples of such characteristics.

The key criteria to be identified, is the entity’s ability to maintain or improve its current standing; be it in the top line or profitability.

Summary
To recap, we began from a macro perspective through recognising the stage of a business cycle in which the economy is presently residing in. Next, we moved deeper into the sectors that fare well during this stage and applied a stock filter to pin point potential gems. Lastly, we seek to understand the business’ fundamentals to better assess the durability of the company’s economic moat.

While it may be a stretch to suggest that the firms you have narrowed down are a definite homerun. This process could uncover stocks that one can potentially ride on in different phases of the business cycle, without the pain of reading through hundreds of annual reports.

Note: The views expressed in this article are solely the writer’s own opinion. It does not reflect CFA Singapore or PhillipCapital’s views or recommendations on investment process.

Currently pursuing his Chartered Financial Analyst qualification, Shane provides coverage on the property, consumer and environmental sectors at Shares Investment.

Please click here for more information about this author.

DBS Group Hldgs  26.620 +0.31 +1.18%   
Business: [FY18 Total Income] Institutional banking (43.7%), consumer banking/wealth management (42.9%), treasury markets and others (13.4%).

Insight: Apr-19, 1Q19 net profit rose 9% to a record $1.7b.... Read More
CapitaLand  3.630 +0.03 +0.83%   
Business: Co develops, owns, and manages real estate properties. [FY18 Geographical] China (41.2%), S'pore (38.5%), Europe & others (18.6%), Vietnam & Others (1.7%).

Insight: Apr-19, 1Q19 revenue fell 23.8% while net profit d... Read More


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