Welcome back to the Cash Cow Couple investing series. If you are new to the site, You may want to refresh with a few of the following articles before proceeding:
We’ll be discussing stock ownership again in this article, and more specifically, the different types of stocks that an investor can own. There are a variety of different stock classifications that can be useful to understand, and the remainder of this article will explain the basics to help you get started.
Based on Ownership Rights
There are two different types of stock that investors can own. Each provides different ownership rights and growth potential.
When people talk about stocks they are usually referring to common stock, and the great majority of stock is issued as common stock. Common stock represent ownership in a company and a claim on a portion of that companies net profits. Common stockholders can also vote to elect the board of directors (who oversee management).
Historically, common stock has yielded higher returns than most other investments. In addition to higher returns, common stock also carries significant risks. If a company goes bankrupt, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid. This risk can be reduced by owning a variety well-established stocks that have solid financial statements and a history of strong earnings (diversification).
Preferred stock represents some degree of ownership in a company but usually doesn’t come with the same voting rights. With preferred shares, investors are usually guaranteed a fixed dividend. Unlike common stock, preferred stock doesn’t usually provide the same appreciation (or depreciation in market downturns) in stock price, which results in lower overall risk and returns. One advantage of preferred stock is that in the event of bankruptcy, preferred shareholders are paid off before the common shareholder (but still after debt holders).
I like to think of preferred stock as falling somewhere in between bonds and common stock. It shares similarities with both. As a result, I wouldn’t hold preferred stock. I don’t really see any reason to forego the growth potential of common stock, or the additional safety provided by bonds. For me, it’s a hybrid that doesn’t belong in my portfolio.
Based On Company Style
Each company that issues stock has a unique plan for growth and dividend distributions, which is reflected in the stock classifications below.
Income stocks typically pay a regular quarterly dividend to shareholders. These are usually high-quality, well-established companies with a history of strong profits and steady dividend increases. Retirees often buy these stocks to secure a steady income stream in the form of dividends. When you combine the dividend payments with the appreciation in stock price, these stocks often provide retirees with more money than they can earn by investing in bonds or other fixed income investments. Of course, this comes with higher risk that the stock price will fall in a market downturn.
Many publicly traded energy and utility companies are good examples of income stocks.
Value stocks usually have one or more of the following characteristics:
- Low price-to-earnings ratio
- Low price-to-book ratio
- Low price-to-dividend ratio
In other words, these stocks are underpriced when compare to other similar companies in the stock market. Sometimes this is a result of financial distress or management problems. Other times, it may be due to investor sentiment and cyclical trends. Regardless of the reason, value stocks have outperformed growth stocks over the last century.
Many times, “value investors” consider factors beyond the financial metrics when considering value stocks. They will evaluate company leadership and other qualitative factors before buying the stock of any particular firm. Of course, this is very difficult for the average investor today, despite what Warren Buffet has to say.
Growth stocks are stocks of companies with profits that are increasing quickly. This increase in profits is accompanied by a rise in the company’s stock price. These companies often reinvest the profits and pay little to no dividends to stock owners. In doing so, they hope that the growth in stock price is enough to keep stockholders on board.
Growth companies are often technology-centered, and many experience rapid growth over short periods of time. During rapid growth, stock prices can grow faster than underlying earnings, which results in high price/earning (P/E) ratios. If the price per share outpaces earnings growth for an extended period of time, the stock can experience a significant downturn. For this reason, I prefer value stocks over growth stocks.
Based On Size
Market capitalization (market cap) refers to the size of a company. You can calculate the market cap of any firm by multiplying the number of outstanding shares by the current stock price.
For example, if a company had 100 million shares of common stock outstanding and a current stock price of $50 per share, its market cap would be $5 billion (100 million x $50).
Investors usually lump companies together according to market capitalizations. Although there is no universal agreement on the exact category cutoffs, here are values that I prefer:
- Mega-cap: Over $100 billion
- Large-cap: $20–100 billion
- Mid-cap: $2–$20 billion
- Small-cap: $250 million–$2 billion
- Micro-cap: $50–250 million
- Nano-cap: Below $50 million
The size of a company is very important in stock pricing because there is a strong correlation between size and risk. Small companies are generally far more risky than large companies because they have fewer resources available, a less well-defined position in the marketplace, and are more susceptible to economic downturns.
As a result of increased risk, nano-cap stocks have produced higher returns than small-cap and mid-cap stocks over the last century. Similarly, small-cap stocks have outperformed large-cap and mega-cap stocks. For this reason, many investors choose to allocate more of their portfolio to smaller stocks, also called a “tilt.”
Summary of the Different Types of Stocks
- Most investors choose to invest in common stock instead of preferred stock. The growth (and loss) potential is higher.
- Income stocks provide steady dividend payments, which can be attractive to retirees and other investors.
- Value stocks, which trade at a lower price relative to earnings than growth stocks, tend to perform well over long periods of time.
- Growth stocks tend to perform well during times of economic prosperity, but very poorly during periods of economic turmoil.
- The stock of smaller companies is expected to outperform larger companies due to the increased volatility (risk).
If you would like to have someone else manage your portfolio, Betterment (see my review) or Wealthfront (see my review) are fantastic options at just 0.25% annually in fees. Either firm will “tilt” your portfolio to include small-cap and value stocks in the U.S. and abroad.