Types of Common Stock
by
Charles Lamson
Common stocks are often classified on the basis of their dividends or their rate of growth in EPS (earnings per share). Among the more popular types of common stock are blue chip, growth, tech stocks, income speculative, cyclical defensive, mid-cap, and small-cap stocks.
Blue-Chip Stocks
These are the cream of the common stock crop; blue chips are stocks that are unsurpassed in quality and have a long and stable record of earnings and dividends. They are issued by large, well-established firms that have impeccable financial credentials---firms like GE, Wal-Mart, Citigroup, Microsoft, 3M Co., United Parcel Service, and Pfizer. These companies hold important, if not leading, positions in their industries and often determine the standards by which other firms are measured. Blue chips are particularly attractive to investors who seek high-quality investment outlets that offer decent dividend yields and respectable growth potential. Many use them for long-term investment purposes, and, because of their relatively low-risk exposure, as a way of obtaining modest but dependable rates of return on their investment dollars. They are popular with a large segment of the investing public, and as a result, are often relatively high priced, especially when the market is unsettled and investors become more quality conscious.
Growth Stocks
Stocks that have experienced, and are expected to continue experiencing, consistently high rates of growth in operations and earnings are known as growth stocks. A good growth stock might exhibit a sustained rate of growth in earnings of 15 to 20 percent (or more) over a period during which common stocks are averaging only 6 to 8 percent. Starbuck's, Lowe's, Medtronic, Harley-Davidson, Kohl's, and Boston Scientific are all prime examples of growth stocks. These stocks normally pay little or nothing in dividends, because the firm's rapid growth potential requires that its earnings be retained and reinvested. The high growth expectations for these stocks usually cause them to sell at relatively high P/E (price/earnings) ratios, and they typically have betas in excess of 1.0. Because of their potential for dramatic price appreciation, they appeal mostly to investors who are seeking capital gains rather than dividend income.
Tech Stocks
Over the past 10 to 15 years, tech stocks have become such a dominant force in the market that they deserve to be put in a class all their own. Tech stocks basically represent the technology sector of the market, and include all those companies that produce or provide technology-based products and services such as computers, semiconductors, data storage devices, computer software and hardware, peripherals, Internet services, content providers, networking, and wireless communications. These companies provide high-tech equipment, networking systems, and online services to all lines of businesses, schools, healthcare facilities, communications firms, governmental agencies, and home users. Although some of these stocks are listed on the NYSE and AMEX, the vast majority are traded on the Nasdaq. These stocks, in fact, dominate the Nasdaq market and as such, the Nasdaq Composite Index and other Nasdaq measures of market performance. They were the ones that were hammered especially hard during the market fall of 2000-02, when the tech-heavy Nasdaq Composite fell nearly 80 percent. Indeed, many tech stocks fell to just pennies a share, as literally hundreds of these firms simply went out of business. But the strongest did survive, and some even thrived.
There are literally thousands of companies that fall into the tech stock category, including everything from very small firms providing some service on the Internet to huge multinational companies. These stocks would likely fall into either the growth stock category (see above) or the speculative stock class (see below), though some of them are legitimate blue chips. Although tech stocks may offer the potential for attractive (and in part anyway) are probably most suitable for the more risk-tolerant investor. Included in the tech-stock category you will find some big names, such as Microsoft, Cisco Systems, Applied Materials, and Dell, as well as many not-so-big names such as BEA Systems, NVIDIA, Invitrogen, KLA-Tencor, and Rambus.
Income Stocks Versus Speculative Stocks whose appeal is based primarily on the dividends they pay out are known as income stocks. they have a fairly stable stream of earnings, a large portion of which is distributed in the form of dividends. Income shares have relatively safe and high level of current income from their investment capital. An added (and often overlooked) feature of these stocks is that, unlike bonds and preferred stock, holders of income stock can expect the amount of dividends paid to increase over time. Examples of income stock include J.P. Morgan Chase, Hershey Foods, Pitney Bowes, R.R. Donnely, AT&T, Bank of America, and PPG Industries. Because of their low risk, these stocks commonly have betas (The beta of an investment indicates whether the investment is more or less volatile than the market as a whole.) of less than 1.0.
Rather than basing their investment decisions on a proven record of earnings, investors in speculative stocks gamble that some new information, discovery or production technique will favorably affect the growth of the firm and inflate the price of its stock. For example, a company whose stock is considered speculative may have recently discovered a new drug or located a valuable resource, such as oil. The value of speculative stocks and their P/E ratios tend to fluctuate widely as additional information with respect to the firm's future is received. The betas for speculative stocks are nearly always all in excess of 1.0. Investors in speculative stocks should be prepared to experience losses as well as gains, since these are high-risk securities. They include companies like P.F. Chang's China Bistro, Quicksilver, K-Swiss, Indexx Labs, Serena Software, and Dollar General.
Cyclical Stocks or Defensive Stocks
Stocks whose price investments tend to follow the business cycle are called cyclical stocks. This means that when the economy is in an expansionary stage (recovery or expansion), the prices of cyclical stocks increase, and during a contractionary stage (recession or depression), they decline. Most cyclical stocks are found in the basic industries---automobiles, steel, and lumber, for example; these industries are sensitive to changes in economic activity. Investors try to purchase cyclical stocks just prior to an expansionary phase and sell just before the contraction occurs. Because they tend to move with the market, these stocks always have positive betas. Caterpillar, Genuine Parts, Maytag Corp., Rohm & Haas, Alcoa, and Tinken are examples of cyclical stocks.
The prices and returns from defensive stocks, unlike those of cyclical stocks, are expected to remain stable during periods of contraction in business activity. For this reason, they are often called countercyclical. The shares of consumer goods companies, certain public utilities, and gold mining companies are good examples of defensive stocks. Because they are basically income stocks, their earnings and dividends tend to hold their market prices up during periods of economic decline. Betas on these stocks are quite low and occasionally even negative. Bandag, Checkpoint Systems.
Mid-Caps and Small-Caps
In the stock market, a stock's size is based on market value---or, more commonly, on what is known as its market capitalization or market cap. A stock's market cap is found by multiplying its market price by the number of shares outstanding. Generally speaking, the market can be broken into three major segments, as measured by a stock's market "cap":
Small-cap---Stocks with market caps of less than $1 billion Mid-cap---Market caps of $1 billion to $4 or $5 billion Large-cap---Market caps of more than $4 or $5 billion
In addition to these three segments, another is reserved for the really small stocks, known as micro-caps. Many of these stocks have market caps below $100 million (some as low as $10 to $15 million), and should only be used by investors who fully understand the risks involved and can tolerate such risk exposure.
Of the three major categories above, the large-cap stocks are the real biggies, the Wal-Marts, GEs, and Microsofts of the world. Many of these are considered to be blue chip stocks, and, although there are far fewer large-cap stocks than any of the other market cap categories, these companies account for about 80 to 90 percent of the total value of all U.S. equity markets. Just because they are big, however, does not mean they are better. Indeed, both the small- and mid-cap segments of the market tend to hold their own with, or even outperform, large stocks over time.
Mid-cap stocks are a special breed unto themselves and offer investors some very attractive return opportunities. They provide much of the sizzle of small-stock returns, but without all the price volatility. At the same time, because they are fairly good-sized companies, and many of them have been around for a long time, they offer some of the safety of the big, established stocks. Among the ranks of the mid-caps are such well-known companies as Tootsie Roll, Wendy's International, Barnes & Noble, PetSmart, and the Cheesecake Factory, in addition to some not-so-well-known names. For the most part, although these securities offer a nice alternative to large stocks without all the drawbacks and uncertainty of small-caps, they probably are most appropriate for investors who are willing to tolerate a bit more risk and price volatility.
Some investors consider small companies to be in a class by themselves. They believe these firms stocks hold especially attractive return opportunities, which in many cases, has turned out to be true. Known as small-cap stocks, these companies generally have annual revenues of less than $250 million, and, because of their size, spurts of growth can have dramatic effects on their earnings and stock prices. Green Mountain Power, Hancock Fabrics, Hot Topic, JoAnn Stores, and Sonic Corp. are just some of the better known small-cap stocks. Now although some small-caps (like Sonic, for example) are solid companies with eaqually solid financials, that is definitely not the case with most of them. Indeed, because many of these companies are so small, they do not have a lot of stock outstanding, and their shares are not widely traded. In addition, small company stocks have a tendency to be "here today gone tomorrow." Although some of these stocks may hold the potential for high returns, investors should also be aware of the very high risk exposure that comes with many of them.
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 513-515*
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