10 beaten down cyclical shares that could lead a future recovery

Much of the focus has been on defensive stocks built to see investors through hard times. But with economically sensitive shares having fallen so far, stock screen expert Ben Hobson hunts for those that could benefit most when conditions improve.

Stock markets have been hard on investors this year, but it’s undeniable that shares in some sectors have done much better than others. Defensive industries like consumer staples, healthcare and utilities have held up reasonably well in the bearish conditions.

But after such a strong sell-off elsewhere in the market, there is now an argument that good quality shares in more cyclical industries look compelling - even if they continue to suffer in the near term. interactive investor’s Graeme Evans has looked at some of the year’s biggest cyclical fallers here. So what kind of stock screening rules could you be using to find sensible investment opportunities?

• Find out about: Trading Account  | Share prices today | Top UK shares

Diversification is the only free lunch

Economic conditions naturally influence different sectors, and the market is constantly trying to anticipate how the changing outlook will affect performance.

This year, those market mechanics have been very clear. Faced with rising inflation and the threat of recession, investors have gravitated to sectors that have historically been better at resisting economic pain. And it has paid off.

For instance, consumer staples industries like food production, household goods, beverages and tobacco tend to be more robust when consumer finances are under pressure. It’s the same with healthcare and utilities. They both have the advantage of being must-haves in good times and bad.

But while defensive industries can be more dependable in bad times, they’re not as exciting or potentially profitable in good times. By contrast, sensitive and cyclical industry sectors are much more reliant on the state of the economy. So when there is a recovery on the horizon, they will be the first to benefit.

Strategies for finding bombed out cyclicals

A good part of the reason why shares in many cyclical sectors have been punished this year is rooted in the deteriorating economy. Rising inflation has increased input costs for firms, which have to pass higher prices on to customers.

The trouble, of course, is that household consumers are seeing prices rise everywhere. That means they’re more sensitive about what they buy and what they pay.

In turn, the Bank of England has been raising interest rates, which directly affects consumer confidence and disposable incomes as mortgage repayments and borrowing costs generally rise.

This melting pot of economic stress is what some economists believe will lead to recession. And that’s just more bad news for companies exposed to the state of the economy.

• The 50% Club: bombed-out cyclical stocks to own when the market turns
• Must read: volatile pound, UK GDP, Bank of England
• The FTSE 100’s future might look like this

Despite the bleak outlook, some firms are better at fending off financial challenges than others. This is where quality is an important factor. Those that have a good record of strong profitability, efficiency and earnings growth are arguably better placed to absorb inflationary pressures and retain customers.

For investors, it’s important to look at profitability signals like these:

• Does the company have strong margins compared to others in the same sector, and are those margins stable over time? High margins can be a pointer to strong profitability and pricing power.
• Is the company good at reinvesting its capital and generating profits quickly? A high Return on Capital Employed (ROCE) can be a signpost to firms that are lean, well managed and adept at allocating their cash.
• Are earnings-per-share growing? As the economy recovers from the Covid pandemic, earnings are bouncing back in many of those firms that survived. But are they forecast to keep growing in the face of economic uncertainty?
• What does the valuation tell you? Some cyclicals have sold off incredibly hard, which has pushed price-to-earnings (PE) ratios low in places. But some haven’t been punished anywhere near as badly - so it’s worth remembering that some cyclicals may not be as cheap as you might think.

This screen focuses on the consumer cyclicals (also called ‘discretionary’) industry, which is sensitive to economic conditions and consumer confidence. It looks for high average profitability measures and earnings that have grown last year and are forecast to grow again in the year ahead. It looks for strong balance sheet health, with a minimum Piotroski F-Score (of financial health) of at least 5 out of a possible maximum score of 9.

Also included is the price performance of each share relative to the FTSE 350 so far in 2022, plus their PE ratios.

Source: SharePad

Has the market priced in the worst?

A standout theme in this list is that housebuilders have been beaten down a great deal this year, with a number of them trading on single-figure PE ratios. Among them are Vistry Group (LSE:VTY), Taylor Wimpey (LSE:TW.) and Bellway (LSE:BWY). Housebuilders often look cheap because of their highly cyclical nature. They were among the biggest losers during the previous major recession in 2009 - but they were also among the big early winners in the recovery.

This time around they face challenges on multiple fronts, with rising interest rates affecting homebuyers and rising input prices pushing up construction costs. That said, the sector does have the benefit of a structural deficit in the supply of homes in the UK, which isn’t going away.

Elsewhere, a couple of retailers make the list in the form of Next (LSE:NXT) and Dr. Martens Ordinary Shares (LSE:DOCS). Both have solid quality hallmarks, with Next being very highly regarded for many years for its capital allocation and profitability. Despite that, the market is clearly concerned that higher price-point fashion could feel the pinch in this consumer spending squeeze.

Finally, note also that these rules pick up three shares that are trading ahead of the FTSE 350 index this year: Burberry Group (LSE:BRBY), RELX (LSE:REL) and InterContinental Hotels Group (LSE:IHG). On an absolute basis, all three shares are either flat or negative for the year, so they have still seen price pressure. But these are well-known high-quality shares on notably higher PE ratios that reflect continued support in the market.

• The 100-year decline of the British pound from five to one dollar
• Barratt Developments dividend yield nears 11% after latest share slump

Overall, this approach to screening for good quality cyclicals shows that the market has become very nervous about some sectors this year. With prices falling in excess of 40% in many cases, the heady mix of economic pressures is now reflecting in some heavily marked down shares.

With uncertainty still higher than normal, it could be that these shares see further weakness. But for investors with longer term outlooks and an eye for future recovery, these sectors could offer opportunities.