Narwhal Finance Word of the Week: Cyclical vs. Secular Companies

Welcome back to our weekly installment of the Narwhal Finance Word of the Week blog series! For those that have yet to read last week’s post (which you can find here), NFWOTW is a series of short blog posts which aims to promote the financial literacy of our clients by selecting one word (well, I guess today it’s two words) from the world of finance to briefly define and discuss each week. This week’s post will briefly dive into what makes a company cyclical or secular and how that affects our investment strategy for both types of companies.

First, it should be noted that when we say a company is cyclical or secular, we’re not just talking about trends in its share price, but also trends in its financial data: things like revenue, margins, profits, etc. Analyzing these trends and classifying them as cyclical or secular is a critical step in developing investment strategies for different companies because it is a useful tool for forecasting what future returns on investments may look like.

So, what makes a company cyclical or secular? I’m so glad you asked! Cyclical companies have cyclical trends, which are shorter in nature compared to secular trends. These trends can be seasonal or may last as long as an entire market cycle. An example of a cyclical trend would be a coat factory’s revenue being high in the winter and low in the summer. Cyclical trends often repeat over multiple market cycles, so they are relatively predictable. It would be quite out of the ordinary for Burlington to crush its winter revenue numbers from the previous quarters during the summer months, barring an extreme reversal in global climate conditions, that is.

Secular companies, on the other hand, have secular trends, meaning that they have trends that persist from season to season or market cycle to market cycle. Secular trends are expected to stick around long-term and are usually the result of an aspect of the company that is fairly dependable. An example of a secular trend would be a military technology company maintaining a consistent revenue stream through a change in presidential administrations. Secular trends are also predictable because they are consistent in nature. Unless all of the world’s leaders suddenly agree to a perpetual world peace agreement, the US government will continue to demand airplanes from Lockheed Martin even if the administration isn’t particularly keen on defense spending.

Once you identify a company as cyclical or secular based on the nature of its trends, you will have a better idea of how it will perform during changing economic conditions. Cyclical companies have an increased opportunity to capitalize on periods of economic expansion, as a combination of solid financial performance and the market cycle going in a positive direction could send the company’s share price on a run. However, for the same reason why cyclical companies tend to boom during economic expansion, they are also prone to struggle during recessions. Conversely, secular companies are good to hold for downside protection during recessions but have less potential for big runs during economic expansion.

Labeling a company as cyclical or secular is very helpful in determining when and how to exit a position because it allows you to put a timeframe on your investment. Typically, it is better to hold cyclical companies for a shorter time period to potentially capitalize on a market cycle run, but it is better to hold secular companies for a longer time period to take advantage of steady long-term gains. For this reason, at Narwhal, our core stock portfolio is made up of companies that we believe have secular trends, while we move in and out of cyclical companies to maximize short-term gains.

Hopefully, this article has provided you with a new tool in your investing toolbox. Understanding the differences between cyclical and secular companies is an important step in becoming a more knowledgeable investor. Plus, when one of your coworkers inevitably asks you why his prized snowmobile manufacturing company stock always struggles in July, you’ll know exactly what to tell him. As always, thanks for reading and we’ll see you next week!

This week’s shoutout goes to our multitalented Equity Analyst/Portfolio Manager Sam Frost, who kindly provided the expert insights for this week’s post. Thanks, Sam!