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Cycles to your advantage

L&T Mutual Fund is adding a formidable new weapon to the armory of the Indian equity fund investor with its new Business Cycles Fund

In the mind of many of us who invest in equity mutual funds, the map of the equity markets is very simple: Companies are large or small; and companies belong to different sectors or industries. We think that mutual funds can either be fully diversified-meaning that they will invest in any company regardless of size or sector; or they can be specific to a size or sector. So we think of large-cap or mid-cap funds; and, for example, technology or banking funds.

However, a revolutionary new fund from L&T Mutual Fund is about to add a new--and far more useful-dimension to this way of classifying companies. Of course, this new dimension has been used by sophisticated equity investors for quite some time. However, it's one of a kind in the world of Indian mutual funds and adds a powerful new weapon in the arsenal of the Indian fund investor. This fund is the 'L&T Business Cycles Fund'. As the name indicates, the fund's investment strategy is linked to something called 'Business Cycles'. To better appreciate how one can use this concept-and L&T MF's new fund-to enhance one's investment returns, let's take a closer look at this concept of business cycles.

Here's what Wikipedia has to say: 'The term business cycle (or economic cycle or boom-bust cycle) refers fluctuations in aggregate production, trade and activity over several months or years in a market economy. The business cycle is the upward and downward movements of levels of gross domestic product (GDP) and refers to the period of expansions and contractions in the level of economic activities (business fluctuations) around its long-term growth trend. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).'

Business cycles are a reality in all economies. For example, as any investor would realise, the Indian economy has gone through three such cycles in the last two decades and is likely entering a fourth one now. The interesting part comes in managing investments through these cycles.

Normally, one would assume that an equity investor has no choice but to suffer during the contraction phase of the business cycle. After all, this is what most of us did during the cycles of the past years. Typically, we stay invested during the positive phase, and then redeem our money and run away to fixed-income or other such investments during the negative phases.

However, the assumption that this is the only choice is not actually true. There is a way to get good returns during the negative phase also, and that way is to follow an investment strategy that takes into account the concepts of 'Cyclical Stocks' and 'Defensive Stocks'. Let's see what these are:

Cyclical Stocks: A stock whose earnings are affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies that sell discretionary items that consumers can afford to buy more of in a booming economy and will cut back on during a stagnation. A few examples of companies whose stocks are cyclical include car manufacturers, consumer electronics, airlines, clothing, hotels and restaurants. When the economy is doing well, people can afford to buy new cars, upgrade their gadgets, vacation, travel etc. When the economy is in a stagnation phase, these discretionary expenses are some of the first things consumers will cut.

Proven past performance

Research of past trends shows something fascinating-the scale of success that such a strategy can bring. Consider this:

  • From December 2003 to December 2007 (when the Indian economy was in a growth phase) cyclical stocks delivered mean returns of 45 per cent returns compared to 20 per cent from defensive stocks. In contrast, between December 2007 and December 2013, when the economy shrank, cyclical stocks delivered mean returns of minus 0.78 per cent, compared to a positive 16 per cent from defensive stocks! That's a massive difference, and one that can do wonders for your returns.
  • Here's the impact such a strategy could have had: In the 10-year period between December 2003 to December 2013, a business cycle based investment strategy would have delivered about 27 per cent returns, whereas as any other themespecific strategy-sector-specific only etc, would have delivered less than 20 per cent.

Source: ICRA MFIE, from 31st Dec 2003 to 31st Dec 2013. Performance of cyclical stocks is shown as an average of S&P BSE Auto, S&P BSE Bankex, S&P BSE Consumer Durables, S&P BSE Capital Goods & S&P BSE Metals performance. Performance of Defensive stocks is shown as an average of S&P BSE FMCG, S&P BSE Healthcare and S&P BSE IT performance. Composite indices are calculated assuming weights are rebalanced on a monthly basis. ^ for FY 04 to FY 08. * FY 09 to FY 14. Past performance may or may not be sustained in the future. The aforesaid charts are given as an example to show performance of the cyclical and defensive stocks in the past and there is no guarantee that the performance results will be same in future.

Defensive Stocks: A stock that has constant and stable earnings regardless of the state of the overall stock market or the economy. These are also known as a 'non-cyclical stock' because they are not dependant on the upwards phase of the business cycle. These are companies providing basic necessities which customers will not cut down upon even when their expenses are strained. Healthcare, utilities, education and staple consumables are some typical examples.

Clearly, instead of running away when the business cycle turns stagnant, a far better strategy would be to shift focus to cyclicals when the cycle is in its upwards phase and to defensives during the stagnant phase.

However, for the individual investor buying and selling equities directly, this is easier said than done. To implement this as a strategy needs not just a lot of research and analysis but continuous attention. L&T Mutual Fund now has a turnkey solution for taking advantage of the business cycle in the form of the new L&T Business Cycles Fund.

While there's nothing to stop the fund manager of any diversified equity fund to try and benefit from business cycles, L&T Business Cycles Fund has the advantage of being able to tune its entire portfolio and thus take such advantage wholeheartedly.

Clearly, the L&T Business Cycles Fund could be significant new option that the Indian equity investor now has in the everlasting quest to get better returns.