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 Lennar Corporation (NYSE:LEN) 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).
A construction crew installing roof tiles on a newly built row home.
Lennar Corporation (NYSE:LEN)
Number of Hedge Fund Investors In Q1 2024: 75
Lennar Corporation (NYSE:LEN) is a major American home builder with a presence all over the country. Being a home builder means that the firm relies on low interest rates to fund its growth. This is true for the demand side and the supply side of Lennar Corporation (NYSE:LEN)’s business. The demand side relies on low rates to take out affordable mortgages, while the supply side relies on low rates to finance large building projects. Given that the market adjusted its rate cut expectations in April, it’s unsurprising that Lennar Corporation (NYSE:LEN)’s shares are down by 6.7% since then. However, the settlement of a historic home brokerage commission lawsuit earlier this year could see commissions drop and inject more demand into Lennar Corporation (NYSE:LEN)’s market. Additionally, in today’s high rate environment, the firm has proven to be quite agile. It is transitioning to an ‘asset light’ model through which it expects to reduce land holdings and reduce exposure to land speculation and high carrying costs.
Baron Funds was gushing about Lennar Corporation (NYSE:LEN)’s asset light model in its Q1 2024 investor letter. Here is what the firm said:
We are bullish on the long-term prospects for Lennar. We believe the company is exceptionally well run, favorably positioned to generate compelling long-term growth, and committed to unlocking shareholder value through several strategic initiatives.
Given its massive size (the company delivered 80,000 homes across its national footprint in 2023), Lennar benefits from important scale advantages that enable the company to attract labor, procure materials, and acquire land more easily and at more favorable pricing than its smaller competitors. Lennar is using these advantages to transition its business model into a “capital-light manufacturing operating model” whereby new homes are “manufactured” at a consistent pace throughout the year while employing a “land-light” strategy to reduce capital requirements. This transition is enabling Lennar to more easily meet its growth objectives (grow new home deliveries by approximately 10% per year) while improving operating and capital efficiency and reducing business risk. The transition has also led to improved cash-flow generation, which the company has been deploying for debt repayment, dividends and share purchases. The company is now sitting on approximately $5 billion of cash, which equates to approximately 11% of Lennar’s market capitalization. We anticipate that a large portion of this cash will be returned to shareholders via share repurchases. We are excited about this business transition and think it may lead to a higher valuation multiple over time.
We are also encouraged that management is exploring taking additional steps to create shareholder value by reducing capital intensity and simplifying the company. For example, last month management discussed the prospect of spinning off as much as $4 billion of land assets into a separate entity. Management may also monetize its partial interest in a large multi-family portfolio via the sale of the portfolio.
Although we are pleased with the strong recent share price performance of Lennar, we still underwrite compelling annual returns over the next few years, as we expect Lennar to compound book value per share at a mid-teens rate and see potential for the valuation multiple to expand further.
Overall LEN ranks 7th 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 LEN 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 LEN but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article is originally published at Insider Monkey.
