Cyclical versus Defensive Sectors and the Business Cycle

What you will learn

• The difference between cyclical and defensive sectors, and why the line is not fixed.
• The four phases of the business cycle and the typical sector pattern linked to them.
• How operating leverage turns a small revenue change into a large profit change.
• How to calculate the degree of operating leverage (DOL) for a company.

Explanation

The business cycle is the repeated sequence of economic expansion and contraction. A useful model has four phases: early recovery (output starts to grow after a recession), expansion (growth is broad, employment rises), late cycle (capacity is tight, inflation and interest rates tend to rise) and recession (output falls). The phases have no fixed length and are often only recognised afterwards.

Cyclical and defensive

A cyclical sector sells things customers can postpone: cars, machines, chemicals, travel, new buildings. Revenue rises and falls with the economy. Typical examples are Consumer Discretionary, Industrials, Materials and Energy, and in some cycles banks.

A defensive sector sells things people keep buying in a recession: food, household products, medicines, electricity. Typical examples are Consumer Staples, Health Care and Utilities.

The classification is a tendency, not a law. A luxury goods maker can be more stable than expected, and a utility with large trading activities can be less stable. Judge each company by its own revenue history and cost structure.

Why profits move more than revenue: operating leverage

The contribution margin, introduced in the business course, is revenue minus variable costs. Variable costs change with output (raw materials, energy per unit). Fixed costs stay roughly the same in the short term (factories, staff, rent, depreciation). EBIT (earnings before interest and taxes, see the stocks course) is contribution margin minus fixed costs.

Operating leverage describes how much EBIT changes when revenue changes. It is high when fixed costs are a large share of total costs. The degree of operating leverage (DOL) is:

DOL = contribution margin ÷ EBIT

and, for small changes, % change in EBIT ≈ DOL × % change in revenue. A DOL of 4 means a 10% fall in revenue cuts EBIT by about 40%. Cyclical sectors combine volatile revenue with high operating leverage, which is why their profits can swing so strongly. Debt adds a second layer (financial leverage), because interest is also a fixed cost.

The typical sector pattern

This table is a teaching model based on historical observation, not a timing rule. Share prices usually move before the economic data, each cycle is different, and interest-rate changes can dominate the pattern. Using it for short-term rotation trades is covered in the swing-trading course; here you use it to understand which economic forces a sector is exposed to.

Worked example

Hypothetical example: two companies, each with revenue of €1,000 million and EBIT of €100 million. Taxes, interest and price changes of inputs are ignored.

• Cyclical AG (machine builder): variable costs 60% of revenue (€600m), fixed costs €300m.
• Defensive SE (food producer): variable costs 75% of revenue (€750m), fixed costs €150m.

Step 1, DOL. Cyclical AG: contribution margin = €1,000m − €600m = €400m; DOL = €400m ÷ €100m = 4.0. Defensive SE: contribution = €250m; DOL = €250m ÷ €100m = 2.5.

Step 2, a recession scenario. Assume Cyclical AG's revenue falls 10% and Defensive SE's falls 3%.

• Cyclical AG: revenue €900m − variable costs €540m − fixed costs €300m = EBIT €60m. Change: −40% (= 4.0 × −10%).
• Defensive SE: revenue €970m − variable costs €727.5m − fixed costs €150m = EBIT €92.5m. Change: −7.5% (= 2.5 × −3%).

Both firms had the same profit at the start. The difference in the recession comes from two sources: a larger revenue fall and a higher operating leverage. This is why earnings estimates for cyclical companies are least reliable exactly when the cycle turns.

Common mistake

Practice activity

A hypothetical chemicals company has revenue of €500 million, variable costs of 50% of revenue and fixed costs of €200 million. (1) Calculate EBIT and the DOL. (2) Calculate EBIT if revenue rises 8%. (3) Check your answer with the DOL shortcut.

Key takeaways

• Cyclical sectors sell what customers can postpone; defensive sectors sell everyday needs.
• Operating leverage (DOL = contribution margin ÷ EBIT) multiplies revenue changes into larger EBIT changes.
• The sector-by-phase table is a historical teaching model, not a timing signal.
• Judge cyclicals on cycle-average earnings, not on the current year.

Next step

The next lesson looks inside one sector in depth: technology and software, their business models and the metrics analysts use for them.