Cyclical shares are very frequently misunderstood by investors. So, just what is a 'cyclical'?
Well, it's a share that is very dependent on business cycles -- one that's affected by the up and down trends of the market it's in.
With many companies, you can just buy a stake and hold for the long-term. But with cyclicals, timing is everything. Buy at the top of an 'up' trend and you could face a substantial loss until the next up one comes round. But if you invest at the right time, you can make a mint.
In this article I will present two cyclical shares, one of which I think you should sell, and the other that I think you should buy.
Mining company BHP Billiton(LSE: BLT) is one of the largest commodity businesses in the world, and is Australia's largest company. Mining, oil and gas firms are all cyclicals. They are dependent on the so-called commodities supercycle, a 10-35 year trend of rising commodity prices.
During a boom, resurgent global economies go on a spending spree, increasing demand for metals, minerals, oil and gas. But limited supply means that prices rocket. Thus, the share prices of commodity companies go through the roof.
But, eventually, the world's economies cool off, and demand falls away. Yet massive investment in production capacity means that supply has over expanded. Thus metal, mineral and hydrocarbon prices tumble, as do the share prices of companies like BHP Billiton.
This is the phase we are in now, and is why BHP's stock valuation has been tumbling. But we're at the early stage of this phase, so there is unlikely to be a rapid revival, and the mining titan is unlikely to see multi-billion pound profits for a while yet. That's why I would sell this firm, and would not buy back in for the foreseeable future.
Another cycle is the ups and downs of house prices. In the early 1990s a recession caused house prices to crash, but economic recovery led to a property boom. Likewise, the Credit Crunch led to sliding house prices, but these are now on the rise as the economy booms once again.
Clever contrarians will know that the best time to invest in house builders is actually during the crashes, because this is the time when most people will not touch these firms with a barge pole.
In the depths of the recent great recession Taylor Wimpey(LSE: TW.) fell to just 20p. If you had been prescient enough to buy in then, you would have nearly ten-bagged on your investment, with shares currently standing at 191p.
And the thing is, the momentum can be so strong with cyclicals that, even now, I would still invest in this company. As, with a 2016 P/E ratio of just 10.82, and a dividend yield of 5.85%, this is still a business that is going cheap.
The lesson is this: cyclicals are the most risky shares. But get on the right side of them and you might just make a fortune.
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Prabhat Sakya has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.