We recently compiled a list of the 10 Best Consumer Cyclical Stocks To Buy Now. In this article, we are going to take a look at where PDD Holdings Inc. (NASDAQ:PDD) stands against the other consumer cyclical stocks.
Consumer cyclical stocks are highly correlated with the economic cycle. Ideally, you’d want to buy them near the bottom of a recession when their prices are lower, anticipating a recovery and rising consumer spending. Essentially, owning consumer cyclical stocks is a bet that the economy will be growing in the near future. This is in contrast to consumer staples, or consumer defensive, stocks which allow investors to position their portfolio to hedge losses in the case of an economic downturn.
Since consumer cyclical stocks are riskier than their defensive counterparts, they offer higher returns and also come with the corresponding increase in risk. Additionally, while determining the risk of consumer defensive stocks might be relatively easy and off the bat calculations can be used, conducting the same exercise for cyclical stocks is trickier. Investors determine a stock’s risk by calculating its beta (β), which measures the tendency of a stock to move with the broader market. Stocks with a β greater than one are more volatile, those with a β less than one are less volatile, and a few (like gold mining stocks) can even have a negative β that makes their share prices move in opposition to the market.
So why is measuring the risk of cyclical stocks tricky? Well, research shows that investors can either rely on a ‘reasonable’ β estimate of 0.7 for defensive stocks or narrow them down by stock sector to define a β that ranges between 0.6 to 0.8. On the flip side, similar shortcuts are unadvised for calculating the β for consumer cyclical stocks. To determine the risk of these stocks, a case by case approach that takes into account the earnings volatility of a firm and the overall business model is recommended.
Building on this, consumer cyclical stocks are dependent on the business cycle for their performance. In fact, data shows that if you’re able to time the business cycle, then investing in consumer staples stocks can provide an opportunity to lead all other market sectors in terms of return. The business cycle is broadly divided into four phases, the early, mid, late, and recession phases. Each phase is marked by unique economic characteristics, and research shows that consumer cyclical stocks perform the best during the first phase. This phase marks the start of a new business cycle after the previous cycle’s recession phase has ended, and its biggest traits are low interest rates and an uptick in economic activity.
Research shows that the first phase of the business cycle is the one that features the highest sector differentiated performance, with the difference between returns spreading to 25 percentage points. The stocks that lead the returns in this period are consumer cyclical stocks since lower interest rates and an uptick in economic activity allow consumers to have higher discretionary spending and enable businesses to expand operations through easy credit. The ‘hit rate’ (which measures the percentage of time periods in the business cycle periods in different cycles over time where the sector outperformed) of cyclical stocks during the early phase is 100%, which ties in with the performance of consumer staples in the late stage among all seven stock market sector performance across all phases of the business cycle. In terms of average returns, consumer cyclical stocks return roughly 12% as a category, implying that individual stocks will offer higher returns as the data is influenced by outliers to a large extent.
Since consumer cyclical stocks are dependent on business cycles to a large extent and also rely on robust consumer spending, the next step in analyzing their performance is to see how spending varies within the cycle. Estimating what stage of the business cycle we’re in is a tricky process, and analysts at the investment bank Morgan Stanley have tried to do so. Their research shows that we are currently in the downturn phase of the cycle, which precedes the early stage we’ve talked about above. We can also try to determine the business cycle’s stage ourselves. Right now, inflation is still trending above trend in America (2.6% PCE in May vs 2% preferred), first quarter GDP growth slowed down (1.6% in Q1 from 3.4% in Q4 2023), and inventories at retailers jumped by 1% annually in February. These three metrics suggest that we might be in the late stage of the business cycle which typically precedes a recession. Consumer spending slows down in the late stages of the business cycles, the downturn and the recession, and neither cycle stage bodes well for consumer cyclical stocks. A key indicator of consumer spending is consumer confidence as it indicates future economic perceptions. On this front, US consumer confidence in March, April, May, and June stood at 103.1, 97, 101.3, and 100.4, respectively. A lower value signals lower confidence, and a value under 80 can signal a recession.
Topping our analysis, let’s take a look at how consumer cyclical stocks have recently fared to check whether the conclusions we’ve reached above are supported by stock market performance. As a refresher, 2024 has been characterized by investors pushing forward interest rate cut expectations and seeking shelter in a few stocks characterized by their strong exposure to the artificial intelligence industry. Two of the most popular consumer staples and defensive stock indexes are those managed by the S&P. Looking at their performance over the past twelve months, these are up by 14.8% and 5.8%, respectively. This is unsurprising since the US GDP has defied expectations during this time period, as it grew by 4.9% and 3.4% in Q3 and Q4 2023 and beat analyst expectations.
However, Q1 2024 GDP growth slowed down to 1.6%, which not only missed analyst estimates of 2.4% but also came with some rather ill-boding expectations for consumer cyclical stocks as spending growth slowed down from its 3.3% growth in the previous quarter to 2.5% in Q1. This figure also sat well below Wall Street’s 3% estimate. The data was released in April, and the previous release which saw the 0.4% inflation reading for March outdo analyst estimates triggered a 6% drop in the consumer cyclical stock index over the next nine days. Since then, the index has gained 6.57%.
Our Methodology
To select the best consumer cyclical stocks to buy, we ranked the 40 biggest consumer cyclical stocks in terms of market capitalization stocks by the number of hedge funds that had held a stake in them during Q1 2024. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
PDD Holdings Inc. (NASDAQ:PDD)
Number of Hedge Fund Investors In Q1 2024: 76
PDD Holdings Inc. (NASDAQ:PDD) is an online retailer that is known for its Pinduoduo platform in China and the Temu platform globally. While retailers are highly sensitive to economic cycles, PDD Holdings Inc. (NASDAQ:PDD) is one of the most unique firms in its industry. This is evident in its analyst share price targets. The average of 37 one year analyst share price targets for PDD Holdings Inc. (NASDAQ:PDD) is $202.67, which marks a hefty 44.7% upside over the recent closing price of $140. The shares are rated Strong Buy on average. This makes one wonder, why is PDD Holdings Inc. (NASDAQ:PDD) garnering such optimism even though China’s economy is slowing. Well, Pinduoduo’s market share grew to 19% in mid 2023 from 7.2% in 2019 as it leveraged the country’s economic weakness to its advantage. Pinduoduo allows users to bargain in groups, and as it eliminates middlemen from the retailer equation, customers are able to buy products at discounted prices. This provides PDD Holdings Inc. (NASDAQ:PDD) with a considerable advantage and could play in its favor globally as well as it leverages ties with Chinese merchants to ship low cost products overseas. However, trade tensions between the West and China remain a lingering threat and could affect the firm’s plans to expand to international markets if tariffs are placed on Chinese products.
Baron Funds mentioned PDD Holdings Inc. (NASDAQ:PDD) in its Q1 2024 investor letter. Here is what the firm said:
We added to our digitization theme by building a position in PDD Holdings Inc., a leading Chinese e-commerce platform. Founded in 2015, the company has emerged as China’s second largest e-commerce player, capturing approximately 20% market share. In our view, PDD’s competitive moat lies in its team purchase model that facilitates bulk buying through direct partnerships with manufacturers, thereby eliminating intermediaries (e.g., distributors and middlemen) and lowering costs. Key factors driving the company’s meteoric growth include rising consumer demand for affordable products in China amid an economic slowdown, small-scale merchants seeking alternatives to Alibaba, and superior management execution. PDD’s revenue growth outpaces gross merchandize value growth owing to rising take rates as merchants aggressively compete for consumer traffic on the platform. In our view, PDD should continue to gain market share given its dominance in the value-for-money segment, growing affordable branded product offerings, and high operational efficiency. We believe the company’s growth will be further supported by the recent launch of its international e-commerce platform, Temu, which has become one of the fastest growing apps globally. Leveraging China’s excess manufacturing capacity, Temu has strong negotiating power with domestic suppliers and attracts global consumers with competitively priced products. Temu’s recent initiatives to improve unit economics, coupled with achieving variable breakeven in the sizable U.S. market, showcase management’s skill and commitment to sustained growth. We expect PDD to at least double its earnings and free cash flow in the next three years, with the potential for continued compounding thereafter.
Overall PDD ranks 6th on our list of the consumer cyclical stocks to buy. You can visit 10 Best Consumer Cyclical Stocks To Buy Now to see the other consumer cyclical stocks that are on hedge funds’ radar. While we acknowledge the potential of PDD as an investment, our conviction lies in the belief that AI stocks hold greater promise for delivering higher returns, and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than PDD but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
READ NEXT: Analyst Sees a New $25 Billion “Opportunity” for NVIDIA and Jim Cramer is Recommending These 10 Stocks in June.
Disclosure: None. This article is originally published at Insider Monkey.
