Welcome back to the Cash Cow Couple investing series. You may want to refresh with the last article on how the stock market works before beginning this one. It’s all about stocks again today. And more specifically, the different types of stocks that an investor can own.
There are many different types of stocks and different classifications that are used to group stocks together. Let’s take a look at each of these stock classifications.
Based on Ownership Rights
There are two different types of stock that investors can own. They have different ownership rights and different privileges.
Common stock is as it sounds, common. When people talk about stocks they are usually referring to common stock, and the great majority of stock is issued is in this form. Common stock represent ownership in a company and a claim on a portion of that companies profits (dividends). Investors can also vote to elect the board members who oversee the major decisions made by management.
Historically, common stock has yielded higher returns than almost all other common investment classes. In addition to the highest returns, common stock probably also carries the highest risk. 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 greatly reduced by owning many different well established companies (diversification) that have solid financial statements and a history of strong earnings.
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. Recall that this is different than common stock, which has variable dividend payments that fluctuate with company profits. Unlike common stock, preferred stock doesn’t usually enjoy the same appreciation (or depreciation in market downturns) in stock price, which results in lower overall 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 being 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 Specifics
Each company has a unique plan for growth and dividend distributions which is reflected in these stock classifications.
Blue-chip stocks are stocks of the biggest companies in the country. These are usually high quality companies with years of strong profits and steady dividend payments. They are also some of the safest stocks to invest in. Because the companies are large, stable investments, they don’t have as much room to grow. This usually results in steady stock prices, but less upside for investors. As a result, historical returns for very large companies have trailed the returns of smaller companies.
Examples include many companies in the DJIA, or the S&P 500.
Income stocks are often times related to “Blue Chip” stocks. They are stable companies that pay large dividends. Older people who are retired often buy stocks in these stable income companies since it provides them with a steady income stream in the form of dividends (although I think that’s a poor reason). 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 energy and utility companies pay high dividends and are a good example of income stocks.
Value stocks are the stocks of companies that usually have one or more of the following:
- Low price-to-earnings ratios
- Low price-to-book ratios
- Low price-to-dividend ratios
- Low price-to-sales-and-cash-flow ratios
In other words, they are under priced when compare to other like companies in the market. Sometimes this is a result of distress or financial problems. Other times, it may be due to investor behavior and cyclical trends.
Value stocks have outperformed growth stocks over the last century, and as as a result, many investors tilt a portfolio to include more value stocks. There is debate on the correlation between value stocks and additional risk in a portfolio. Some say that a value premium exists to compensate investors because value stocks are definitely more risky than other available investment options, like growth stocks. Other would argue that value stocks are under priced due to investor behavior and inefficiencies in the market. There is supporting research for both.
I personally think that the additional risk is minimal and primarily shows up in certain economic cycles when investors are less risk tolerant and the expected risk premium is high. But I also recognize that past performance is no indication of future performance, and as a result, wouldn’t be surprised if value stocks don’t fare well going forward. Despite all that, I choose to “tilt” my portfolio a small amount towards the value side.
Many times, “value investors” also take a look at factors beyond the relationship between price to earnings and book value when considering value stocks. They will evaluate company leadership and other qualitative factors before buying. 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 reflected in the 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 usually either sell a product or focus on research and design. Most of these companies experience rapid growth. Their stock prices often grow faster than underlying earnings, which results in high price/earning (P/E) ratios. This can continue for a while but stock prices always revert back to the mean historical P/E average, leaving some investors to get burned on these stocks. Growth stocks can rise in value quickly, but they often fall even quicker.
Based On Size
Market capitalization (market cap) is simply a way of referring to the size of a company in a manner that allows you to compare companies in different industries.
You compute market cap 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 categorize companies under one of these labels – although there is not universal agreement on the exact cutoffs.
- Mega-cap: Over $200 billion
- Large-cap: Over $10 billion
- Mid-cap: $2 billion–$10 billion
- Small-cap: $250 million–$2 billion
- Micro-cap: Below $250 million
- Nano-cap: Below $50 million
The size of a company is very important in stock pricing. Investors often talk about investing is small, mid, or large cap mutual funds. This means that the mutual fund only invests in companies of a certain size.
There is a strongly correlation here between risk and return. Small companies are more risky than large companies because they have less resources available, haven’t established themselves as well in the market place, and may not be as well known as the giant stock issuers.
As a result of increased risk, these “small cap” companies have produced higher returns than “mid cap” or “large cap” companies over the century. Continuing the trend, “mid cap stocks” have outperformed “large cap” and “mega cap” stocks.
For this reason, many investors choose to allocate more of their portfolio to small or mid cap stocks, also called a “tilt.” Again, this results in slightly more risk.
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.
- Huge companies are sometimes referred to as “blue chip.” They often pay steady dividends but have less growth potential.
- Income Stocks provide investors with steady dividend payments.
- Value stocks have good fundamental valuations and often pay dividends. They have outperformed growth stocks over the last few decades, which may or may not be a result of increased risk.
- Growth stocks are generally more volatile and tied to economic cycles. They often outrun the underlying company earnings which results in a price correction later on.
- Small Cap stocks have outperformed large cap stocks in recent history, but do involve more risk.
If you are looking to tilt your portfolio toward value companies or smaller companies, consider reading about Betterment. I’ve been impressed with their service. Or if you prefer to buy and sell stocks yourself, Motif Investing is probably your cheapest option.
Hope you learned something about stock classification today. Let me know if I covered all of the different types of stocks or if I missed something.