Question

Which sector rotation would likely occur given the following economic scenario?

            The economy has hit a trough and GDP is expected to expand / grow over the next several years.

		Investors would likely buy cyclical stocks and sell defensive stocks.
		Investors would sell their stocks and purchase bonds
		Investors understand that the economic cycle has nothing to do with mid-term stock returns and GDP growth does not impact company earnings in any way.
		Investors would likely buy stocks with low operating leverage and sell stocks with high operating leverage

Firm A has a debt/equity ratio of 1.9x and their income statement shows that 22% of their costs are fixed costs.

Firm B has a debt/equity ratio of 3.7x and their income statement shows that 91% of their costs are fixed costs.

Given this information and your newly found knowledge of investments, please state which firm's stock should perform BEST on a relative basis in an EXPANDING economic environment.    Assume all else is equal between the two firms (industry, valuation metrics, etc...)

		Firm A should outperform Firm B
		Firm B should outperform Firm A
		Firm A and Firm B should not have a material difference in returns since they are in the same industry and have similar valuation metrics.

Answer 1

1. Investors would likely buy cyclical stocks and sell defensive stocks.

Cyclical stocks like automobile, steel, discretionary goods industries performance is depends on the GDP growth. If GDP growth is going to revive, these cyclical stocks are going to outperform other sectors. hence they should buy.

defensive stocks like pharma, food they are non discretionary and perform well during the GDP slowdown, hence these should be sold off.

2. Firm A should outperform Firm B.

Firm A has low debt (low debt/Equity ratio) which means its interest cost will be lower resulting in better financial effeciency.

Firm A has low fixed costs which means the operational effeciency is very high when comapred to Firm B. Hence, Firm A will perform better than Firm B.