Trading Strategies: a FTSE 100 cyclical share to tuck away

A 50-basis point spike in inflation has prompted widespread concern among investors. After all, January’s inflation rate of 3% is the highest reading since March last year and is significantly above the Bank of England’s 2% target.

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Its rise means that further interest rate cuts could be somewhat less likely in the near term, since it is difficult for any central bank to implement monetary policy easing amid an increase in the pace of inflation. In turn, a higher interest rate typically acts as a drag on GDP growth. This suggests that cyclical firms, which are highly reliant on the economy’s performance, are set to experience a relatively challenging period over the short run.

A worsening situation?

Of course, inflation’s rise to 3% should not come as a major surprise. The Bank of England stated in its February Monetary Policy report that it anticipated an increase in the pace of price rises over the coming months. Indeed, the central bank forecasts that inflation will continue to rise from its current level so that it peaks at around 3.7% later this year.

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This could put additional strain on disposable incomes and may even bring the cost-of-living crisis sharply back into focus. Concerns over whether wage growth can beat inflation have faded over recent months, with total pay having consistently increased in real terms since April 2023. However, a higher rate of inflation and a restrictive monetary policy that is left largely intact over the coming months may mean that consumer spending, as well as sentiment, comes under pressure. This could prompt particularly difficult trading conditions for consumer-focused firms.

Long-term potential

Many investors may understandably seek to avoid cyclical firms that rely on the UK for a large proportion of their sales, given their uncertain near-term outlook. They may naturally judge that investing abroad or buying defensive shares is a far more appealing prospect. While both of those areas have their merits, UK-focused cyclical stocks also offer long-term capital growth potential.

In many cases, they currently trade on attractive valuations due to recent falls in their share prices, as investors have priced in the prospect of a tough short-term outlook. This could enable them to generate strong capital growth in future as their shares upwardly rerate.

Furthermore, a significant number of UK-focused cyclical firms have sound fundamentals that should mean they are well placed to overcome near-term economic difficulties. For example, they may employ only modest amounts of leverage so that they can still afford to service their borrowings despite a moderation in profitability. And in cases where they have a solid market position, they may be well placed to capitalise on a subsequent economic recovery over the coming years.

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Indeed, the long-term outlook for the UK economy remains upbeat. After peaking at 3.7% this year, the Bank of England expects inflation to fall to 2% by the latter part of 2027. This should allow the central bank to implement further monetary policy easing, with it being far simpler to cut interest rates when above-target inflation is falling rather than rising. A looser monetary policy should, once time lags have passed, create a more buoyant operating environment for cyclical firms that translates into higher profits and share price growth.

A buying opportunity

Therefore, now could be an opportune moment to focus on high-quality cyclical stocks that are reliant on the UK for a large proportion of their sales. Although their financial performance and share prices could come under pressure in the short run, a likely fall in inflation and pending interest rate cuts mean that their market valuations may rise from their current low ebb over the long run.

In fact, it could be argued that the best time to buy cyclical stocks is when the economy’s near-term prospects appear to be challenging. History suggests that GDP growth will ultimately recover from its present lacklustre levels, given its inherent cyclicality. Purchasing high-quality stocks that stand to benefit from a recovery while they trade below their intrinsic value could prove to be a worthwhile long-term move.

A falling share price

Source ShareScope. Data as at 25 February 2025. Past performance is not a guide to future performance.

Shares in Marks and Spencer (M&S) have fallen heavily over recent weeks. The FTSE 100 retailer, which generates around 90% of its sales in the UK, has posted a share price decline of 11% since the start of the year. This compares with a 5% rise for the large-cap index. The company’s market valuation, though, is still up 15% since the stock was first discussed in this column during May last year. This is nine percentage points ahead of the return of the FTSE 100 index over the same period.

Investor sentiment towards the firm has materially weakened of late despite the release of a strong Christmas trading update in early January. The company delivered an upbeat performance during the 13 weeks to 28 December, with like-for-like sales growth of 6.4% being generated in the UK and Ireland. However, an uncertain near-term outlook amid elevated inflation and weak economic growth appears to have weighed on its market valuation to at least some extent.

Improving fundamentals

As a result, it now trades on a forward price/earnings (PE) ratio of around 12.2. While this is higher than the ratings of several other cyclical firms, it is not excessive, and the company’s solid fundamentals and long-term growth potential mean it may be worthy of a premium valuation.

Indeed, M&S is making encouraging progress in implementing its strategy. Notably, it is becoming more efficient, with it reporting that structural costs were reduced by £60 million in the first half of the current financial year. This is part of an overall plan to make £500 million in total savings by 2028. This could help to offset the effects of operating cost inflation to at least some extent, thereby protecting its profit margins.

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The firm is also strengthening its market position. It made market share gains in both its Food and Clothing, Home & Beauty divisions in its most recent quarter. While this may not necessarily translate into markedly higher profits in the short run should trading conditions deteriorate, it means the company is well placed to benefit from a likely upturn in its operating environment over the long run.

In the meantime, the company’s improving financial position should allow it to overcome an uncertain trading environment. At the time of its half-year results in September, for example, it reported that net debt had fallen by roughly 16% over the previous 12 months so that it now has a net debt-to-equity ratio of 71%. Net interest costs, furthermore, were covered a healthy 7.9 times by operating profits in the first half of the year.

Risk/reward opportunity

Clearly, M&S faces an uncertain near-term outlook. Higher inflation, a continued restrictive monetary policy and weak GDP growth, as well as rising costs from a higher minimum wage and changes to employer national insurance contributions, could weigh on its financial performance in the coming months. It would therefore be somewhat unsurprising if its share price continues to exhibit heightened volatility compared with the wider FTSE 100 index.

However, with an improving market position, a solid balance sheet and a sound strategy, it is well placed to capitalise on a long-term economic recovery. Although its shares are by no means the cheapest among UK-focused cyclical stocks, the company’s strong fundamentals suggest it is worthy of a premium market valuation.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.