Too many investors can't see the trees for the forest. Being too focused on the general stock market, trying to time the market's ups and downs, they lose sight of the simple fact: In the long run, stocks go up as earnings go up. Let us contrast the earnings of two types of stocks:
Type A: The Cyclical Stock
The cyclical stock is one whose earnings fluctuate with market conditions. In favorable market conditions, earnings and stock price go up; P/E may be low or high, depending on whether the earnings go up more or less than the stock price. Then recessions or depressions come, and the stock price drops along with earnings; P/E may be low if stock price drops more, but could be deceivingly high if the earnings drop more. Many of the Dow (DJIA) stocks fit into this description, for example, DuPont (NYSE:DD), General Electric (NYSE:GE), and Alcoa (NYSE:AA). Below are the earnings-per-share of these three companies over the past 10 years.
What these three companies have in common is that their earnings rise and fall with the economy, down from the recessions of 2002-2003 and 2008-2009, and up in the favorable market conditions of 2006-2007. DuPont's earnings have fallen in 4 of the past 10 years, General Electric's in 3, and Alcoa's in 3. They differ, however, in the extent of their cyclicity. Dupont is only mildly cyclical, as earnings remained positive in all the past 10 years, and show an up trend. General Electric is more cyclical, as earnings remained positive, but show greater variability and no gain over the past 10 years. Alcoa is the most cyclical of all, with earnings turning negative in 2009, and no gain over the past 10 years.
Most Dow stocks are cyclical. Those that are similar to DuPont include Exxon Mobil (NYSE:XOM) and Caterpillar (NYSE:CAT). Those similar to General Electric include Pfizer (NYSE:PFE) and Merck (NYSE:MRK). Those similar to Alcoa include Verizon (NYSE:VZ) and Bank of America (NYSE:BAC).
Type B: The Defensive Stock
The defensive stock is the opposite of the cyclical stock. The defensive stock company sells products or provides services that are in demand in both good and bad economies. Earnings show consistent growth every year with few exceptions, in both favorable and unfavorable market conditions. As a result, the stock price also tends to go up consistently, producing consistent returns. Within the DJIA, Procter & Gamble (NYSE:PG) would be a good example. Take a look at the earnings-per-share of Procter & Gamble over the past 10 year.
Earnings-per-share for Procter & Gamble, 2002-2011.
Procter & Gamble shows minimal cyclicity, with earnings increasing in each of the past 10 years, except for year 2009. Even for year 2009, the decrease is very small.
Which of the two types of stocks make better investments?
That depends on the investor's time frame. Take a look at the short (3 years), intermediate (10 years), and long term (30 years). (Note: For speculators with much shorter time frame than 3 years in mind, earnings do not matter nearly as much as technical analysis and investor psychology.)
Since 2009, cyclical stocks like General Electric and DuPont have done very well, doubling or tripling from their recession lows. Alcoa also did very well in the initial 2 years post recovery, but has since come down. Procter & Gamble, a defensive stock, underperformed not only the cyclical stocks but also the general market, as represented by the S&P 500.
For the past 10 years, however, the story is markedly different. Procter & Gamble, the worst performing stock over the past 3 years, outperformed not only the cyclical stocks, but also the S&P 500. The cyclical stocks, on the other hand, underperformed the S&P 500. Stock prices roughly reflected earnings: those with earning increases over the past 10 years (PG and DD) gained, while those with earning decreases over the past 10 years (AA and GE), dropped.
Over the long run, since 1982, stock price essentially reflected earnings, and Procter & Gamble, the defensive stock, is the best performer. Alcoa and DuPont underperformed the S&P 500. General Electric significantly outperformed until 2000, but has since declined as its business model deteriorated, and its earnings suffered.
Investing in cyclical stocks require market timing. Investors in a cyclical stock must know not only when it has hit a bottom in a business cycle, but also when it has hit a top. Correct timing means great short term profits. DuPont has more than doubled from three years ago. Alcoa doubled in 2 years from its 2009 low, but has since come down. Understanding the business cycle, buying low and selling dear, is the key to cyclical stock investing. Cyclical stocks are generally riskier, and more suitable for active investors who feel compelled to trade frequently and those with a short term investment horizon.
Investing in defensive stocks, in contrast, does not depend on market timing, although timing could certainly help. The key trait of defensive stocks is consistently growing earnings, which drive stock prices over the long term. Conservative investors can sleep soundly investing in defensive stocks like Procter & Gamble, without worrying too much about the stock market or whether they got their timing right. Defensive stocks are generally safer, and more suitable for passive investors and those with a long term investment horizon.
In sum, stocks vary greatly in their performance based on the nature of their earnings. Rather than focusing on the stock market, investors should focus on the individual stocks themselves, looking at earnings for the past 10 years to get a feel for the cyclicity of the stock, to see how the stock may fit with their investment horizon and risk tolerance.
Disclosure: I am long MRK, XOM, WMT.