Sector Cycle: Why do it happen?
Well, I was always puzzled with “Why are certain sectors cyclic & why does this cycle occur?”
So after lot of reading, I will try to explain it in the simplest terms.
Here by cycle I would mean the period during which the sector sees good times and the not so good times. And these periods keep on repeating.
Sector Cycle in simple terms mean the cycle in a sector during which the capacity expands and then contracts. The occurrence of which is seen mostly in commoditized businesses.
The boom period starts when the prices of commodity starts increasing triggering capacity expansion and better margins. This will result only when Demand Leads Supply. And when profitability increases it is accompanied with loosening capital discipline.
The capacity expansion usually is driven by taking debt and at a certain point with the continuous increasing supply, supply outstrips demand.
And at such a junction prices start dropping and making product manufacturing unviable. Those companies that have taken huge amount of debt starts selling assets to meet the debt obligation leading to decrease in capacity. This the bear period of the sector .The declining capacity reaches a stage where demand outstrips supply making the production lucrative again.
You would think “Wow, thats very simple and why would a large company not be careful”. It would seems like a no brainer to enter at the bottom of the cycle and the expansion should be slow and steady but like everything else emotions take control over rational thinking. The executives are humans like us who unlike us is under lot of pressure to show growth.
Same with the current Bull run, everyone is investing as if the market is never going to crash.
For example , Currently there are lot of hue & cry about the NPA issue faced by Indian PSU banks. The culprit being the Steel manufacturing companies such as Bhushan Steel, Essar Steel etc.These companies during the upcycle form 2003-08 undertook mindless expansion backed by easy debt from PSUs. But as soon as the cycle turned, their fortunes took a steep nosedive. Currently Aluminium sector is enjoying its mojo. It would be worthwhile to track how things turn up in the future.
There is a wonderful book on asset cycle called “Capital cycle” which explains this cycle in details.
The typical period for such cycles to go from one phase to another is 5-7 years. Stocks in these sectors should be bought at the time the commodity price starts moving up from the lower levels.