- Earnings season kicked off a couple of weeks ago, with cyclical banks JPMorgan Chase and Goldman Sachs both reporting better-than-expected results.
- They were soon followed by drinks and snacks magnate PepsiCo, which announced strong quarterly results.
- Cyclical bellwether Alcoa then revealed a higher-than-expected profit and forecast for the rest of the year.
- And last week, defensive pharma giant Johnson & Johnson’s second-quarter results were better than expected.
✍️ Connecting The Dots
Companies can broadly be grouped into two categories: cyclicals and defensives. Cyclical companies, as their name suggests, tend to see their earnings rise and fall in line with the economic cycle – or put another way, they earn more when the economy’s growing and less when it’s shrinking. Defensive companies, meanwhile, tend to earn a pretty predictable amount no matter what’s happening economically, since they sell products and services people rely on.
Heading into this earnings season, analysts were predicting north of 60% profit growth from US companies, and around 140% from European companies (though future growth’s expected to be much lower). And with global economic growth at the peak of its bounceback, the second quarter should’ve been the peak of growth for cyclical companies. Defensive companies, on the other hand, shouldn’t have been quite so exciting: you wouldn’t necessarily have bought more tinned food, sodas, or medicines than you did the same time last year.
But it turns out that wasn’t the case at all. While cyclicals like banks and industrial firms have exceeded expectations so far, a lot of that looks like it’s already been “priced in” to near record-high US stocks. As for defensives, they’ve been shooting past expectations, partly because they’ve been able to offset the rising costs of raw materials with price hikes of their own. And as investors worry about the threat of new coronavirus strains, their shares have been rallying at the expense of cylicals.
1. The best choice is both.
The savviest stock market investors have probably had both cyclicals and defensives in their portfolios, with the former allowing them to profit from a recovering economy and the latter offering them both stable income and a hedge against a coronavirus resurgence. It goes to show how well it pays to have a balanced portfolio that covers the majority – if not the entirety – of the market.
2. It all comes down to growth.
Investors are ultimately looking for earnings growth wherever they can find it, since companies that can compound the highest growth over time should see their share prices – and shareholder returns – rise the most. But precisely which companies fall into that bracket changes from time to time: Big Tech has for years been one of the most reliable ways for investors to access consistent earnings growth, and they’re now largely thought of as defensive. But cyclicals have had their time in the sun in the past few months – and if they can promise consistent and high-quality earnings growth for years to come, there’s no reason they can’t take over as investors’ go-tos.
🎯 Also On Our Radar
Fresh data out on Friday showed UK retail sales were 0.5% higher in June than in May, partly as the Euro 2020 soccer tournament encouraged shoppers to stock up on everything from merchandise to snacks. That could help bolster investors’ hopes that the country’s earnings growth – and by extension stock prices – will soon come good, especially given how cheap UK stocks look in a global context.