In addition to the distinctions a company might establish for its shares—such as common or preferred—industry experts often group stocks generally into categories, sometimes called sub-classes.
Common sub-classes, explained in greater detail below, focus on the company’s size, type, performance during market cycles, and potential for short- and long-term growth.
Each subclass has its own characteristics and is subject to specific external pressures that affect the performance of the stocks within that subclass at any given time. Since each individual stock fits into one or more subclasses, its behaviour is subject to a variety of factors.
MARKET CAPITALIZATION
You’ll frequently hear companies referred to as large-cap, mid-cap, and small-cap. These descriptors refer to market capitalization, also known as market cap and sometimes shortened to just capitalization.
Market Cap, is the dollar value of the company, calculated by multiplying the number of outstanding shares by the current market price.
There are no fixed cut-off points for large-, mid-, or small-cap companies, but you may see a small-cap company valued at less than $2 billion, mid-cap companies between $2 billion and $10 billion, and large-cap companies over $10 billion—or the numbers may be twice those amounts. You might also hear about micro-cap companies, which are even smaller than other small-cap companies.
Larger companies tend to be less vulnerable to the ups and downs of the economy than smaller ones—but even the most venerable company can fail. Larger companies typically have larger financial reserves, and can therefore absorb losses more easily and bounce back more quickly from a bad year. At the same time, smaller companies may have greater potential for fast growth in economic boom times than larger companies. Even so, this generalization is no guarantee that any particular large-cap company will weather a downturn well, or that any particular small-cap company will or won’t thrive.
INDUSTRY AND SECTOR
Companies are subdivided by industry or sector. A sector is a large section of the economy, such as industrial companies, utility companies, or financial companies. Industries, which are more numerous, are part of a specific sector.
>>Example: Banks are an industry within the financial sector.
Frequently, events in the economy or the business environment can affect an entire industry. For example, it’s possible that high gas prices could lower the profits of transportation and delivery companies. A new rule changing the review process for prescription drugs could affect the profitability of all pharmaceutical companies.
Sometimes an entire industry might be in the midst of an exciting period of innovation and expansion, and becomes popular with investors. Other times that same industry could be stagnant and have little investor appeal. Like the stock market as a whole, sectors and industries tend to go through cycles, providing strong performance in some periods and disappointing performance in others.
Part of creating and maintaining a strong stock portfolio is evaluating which sectors and industries you should be invested in at any given time. Having made that decision, you should always evaluate individual companies within a sector or industry you’ve identified to focus on the ones that seem to be the best investment choices.
DEFENSIVE AND CYCLICAL
Stocks can also be subdivided into defensive and cyclical stocks. The difference is in the way their profits, and therefore their stock prices, tend to respond to the relative strength or weakness of the economy as a whole.
Defensive stocks are in industries that offer products and services that people need, regardless of how well the overall economy is doing.
For example, most people, even in hard times, will continue filling their medical prescriptions, using electricity, and buying groceries. The continuing demand for these necessities can keep certain industries strong even during a weak economic cycle.
In contrast, some industries, such as travel and luxury goods, are very sensitive to economic up-and-downs.
The stock of companies in these industries, known as cyclicals, may suffer decreased profits and tend to lose market value in times of economic hardship, as people try to cut down on unnecessary expenses. But their share prices can rebound sharply when the economy gains strength, people have more discretionary income to spend, and their profits raise enough to create renewed investor interest
GROWTH AND VALUE
A common investment strategy for picking stocks is to focus on either growth or value stocks, or to seek a mixture of the two since their returns tend to follow a cycle of strength and weakness.
Growth stocks, as the name implies, are issued by companies that are expanding, sometimes quite quickly but in other cases over a longer period of time.
Typically, these are young companies in fairly new industries that are rapidly expanding.
Growth stocks aren’t always new companies, though. They can also be companies that have been around for some time but are poised for expansion, which could be due to any number of things, such as technological advances, a shift in strategy, movement into new markets, acquisitions, and so on.
Because growth companies often receive intense media and investor attention, their stock prices may be higher than their current profits seem to warrant. That’s because investors are buying the stock based on potential for future earnings, not on a history of past results. If the stock fulfils expectations, even investors who pay high prices may realize a profit. Since companies may take big risks to expand, however, growth stocks may be very volatile, or subject to rapid price swings.
>>Example: A company’s new products may not be a hit, there may be unforeseen difficulty doing business in new countries, or the company may find itself saddled with major debt in a period of rising interest rates. As always with investing, the greater the potential for an outstanding return, the higher the risk of loss.
When a growth stock investment provides a positive return, it’s usually as a result of price improvement—the stock price moves up from where the investor originally bought it—not because of dividends. Indeed, a key feature of most growth stocks is an absence of dividend payments to investors. Instead, company managers tend to plow gains directly back into the company.
Value stocks, in contrast, are solid investments selling at what seem to be low prices given their history and market share.
If you buy a value stock, it’s because you believe that it’s worth more than its current price. You might look for value in older, more established industries, which tend not to get as much press as newer industries. One of the big risks in buying value stocks, also known as undervalued stocks, is that it’s possible that investors are avoiding a company and its stock for good reasons, and that the price is a fairer reflection of its value than you think.
On the other hand, if you deliberately buy stocks that are out of fashion and sell stocks that other investors are buying—in other words, you invest against the prevailing opinion—you’re considered a contrarian investor. There can be rewards to this style of investing, since by definition a contrarian investor buys stocks at low prices and sells them at high ones. However, contrarian investing requires considerable experience and a strong tolerance for risk, since it may involve buying the stocks of companies that are in trouble and selling stocks of companies that other investors are favoring. Being a contrarian also takes patience, since the turnaround you expect may take a long time.