Optimists start to look towards cyclical equities

SPREAD betting on individual equities or sectors is a tricky task, especially at the moment when the timing of an economic recovery is still not entirely certain. Overall sentiment is picking up but companies are still downbeat about their future prospects &ndash; so how can spread betters try to make sense of the equity markets and pick stocks with potential?<br /><br />In recessionary times, investors tend to go for defensive stocks, which include pharmaceuticals, utility companies and tobacco companies. These are usually best placed to ride out the recession because their products are needed, regardless of economic conditions, and people will cut back on other, less essential items first.<br /><br />Cyclical stocks &ndash; ie, those that are affected by economic conditions &ndash; are more successful during a period of expansion.<br /><br />Sector rotation theory looks at how sectors have performed historically at different stages of the economic cycle. It suggests that industrials, basic resources and energy are the best stocks to go for in the early phases of a recovery when consumer expectations are typically rising, industrial production is growing and interest rates have bottomed out.<br /><br /><strong>AVOID DEFENSIVES</strong><br />And the improving data in the US and the UK has meant that Bank of America-Merrill Lynch investment strategists believe that we are through the worst of the recession and expect positive growth in the third quarter.<br /><br />&ldquo;This puts the economy and markets in early-stage cyclical recovery and, despite possible bumps ahead, asset allocation needs to favour cyclicals over defensives,&rdquo; it says in its research.<br /><br />Spread betters would do well to do the same &ndash; if investors are moving into the underlying asset then this will push up the share price, benefiting those trading the derivatives of the market as well.<br /><br />But within cyclical stocks, there are many different trends which can determine how individual stocks will perform relative to each other. Nick Wilson, head of cyclical research at Icap Equities, investigates more detailed investment themes for cyclical stocks in a research note.<br /><br />He breaks down cyclical stocks into three categories, depending on what drives their growth. Firstly, those driven by structural growth &ndash; companies that have three to five years behind them, emerging markets exposure and market leading products. Secondly, secular growth &ndash; companies that have benefitted from a shift in demand over a shorter-term time horizon, but their share price performance could well disappoint. Thirdly, purely cyclical growth fuelled by a recovery in overall economic conditions.<br /><br /><strong>STRUCTURAL GROWTH</strong><br />Wilson says the longer-term &ldquo;winners&rdquo; in the sector are those stocks which most clearly deliver structural growth, and will continue to do so. However, he adds that over the next few months it may be the cyclical stocks which still offer the greater upside with the general market rally. <br /><br />Wilson picks going long on Schneider, a French-listed electrical equipment manufacturer, whose growth is dependent on structural factors. &ldquo;It is a well-run company with an excellent global footprint and has identified sizeable costs to be taken out to further strengthen its position. It has an excellent distribution network and market leading products.&rdquo; And those short-term potential winners, pure cyclical growth stocks like CRH &ndash; an international building materials group &ndash; could be worth taking a long punt on.<br /><br />But not all cyclical stocks should be bought. Wilson recommends shorting Italian carmaker Fiat &ndash; a secular growth cyclical stock &ndash; because it is trying to strike deals to enhance its value rather than addressing the key issues of a conglomerate structure with too high a cost base.<br /><br />Cyclical stocks are the way forward if you believe that we are through the worst. But to be more successful, you&rsquo;ll need to be more discerning about which cyclical stocks you pick.<br /><br />As Wilson notes, what is behind their growth will be a key indicator of likely future success.