Types of common stock

Companies have different characteristics that make their stock prices react differently to economic data. Consequently, you should know the types of stocks that you invest in. Blue-chip stocks pay dividends, and growth stocks generally do not pay dividends. Stocks can be classified into various categories, which is useful for investors because different types of stocks vary with regard to their returns, quality, stability of earnings and dividends, and relationship to the various risks affecting the companies and the market.

Blue-Chip Stocks

Blue-chip stocks refer to companies with a long history of sustained earnings and dividend payments. These established companies have developed leadership positions in their respective industries and, because of their importance and large size, have stable earnings and dividend records. Most companies in the Dow Jones Industrial Average are considered to be blue-chip companies. However, some financially troubled stocks such as AT&T, for example, cut their dividends and were removed from the Dow and replaced with other, more solid companies.

Not all blue-chip companies are the same. For example, Wal- Mart, the largest retailer in the world, pays an annual dividend of $0.88 per share, whereas Merck, the pharmaceutical company, pays an annual dividend of $1.52 per share, and the ExxonMobil annual dividend is $1.40 per share (as of May 2007). Wal-Mart sales and earnings grew rapidly in its early years, during which time it retained its earnings to fuel its growth. In later years it began paying a small dividend. Wal-Mart does not fit into the typical definition of a blue-chip company because it does not pay much of a dividend and has not had a long history of paying out dividends. Merck and ExxonMobil historically also have had growing sales and earnings, but they have elected to pay out a higher percentage of their earnings in dividends and have longer histories of paying dividends.

Blue-chip companies appeal to investors who seek quality companies with histories of growing profits and regular dividend payouts. These types of companies tend to be less risky in periods of economic uncertainty because of their dependable earnings. In bear markets, the stock prices of blue-chip companies tend to decline less than those of growth companies that do not pay dividends. Investors are attracted to blue-chip stocks because they not only provide a store of wealth in anticipation of capital appreciation but also deliver regular dividend income.

Income Stocks

Income stocks have high dividend payouts, and the companies are typically in the mature stages of their industry life cycles. Stocks of companies that have established a pattern of paying higher-thanaverage dividends can be defined as income stocks. Income stocks tend not to appreciate in price as much as blue-chip stocks do because income stock companies are more mature and are not growing as quickly as are blue-chip companies. This statement does not mean that income stock companies are not profitable or are about to go out of business. On the contrary, they have stable earnings and cash flow, but they choose to pay out much higher ratios of their earnings in dividends than other companies do. Utility companies and real estate investment trusts (REITs) are examples of income stocks. American Electric Power (ticker symbol AEP) has a current dividend of $1.56 and a dividend yield of 3.2 percent; Ameren Corporation (ticker symbol AEE) has a current dividend of $1.52 and a dividend yield of 4.7 percent; and NiSource (ticker symbol NI) has a current dividend of $0.92 and a dividend yield of 3.7 percent. These dividends and dividend yields, quoted as of May 11, 2007, were based on the stock prices on that day. The average dividend yield for stocks on the S&P 500 Index was 1.81 percent over the same period. REITs are also classified as income stocks because they are required to pass on most of their earnings to shareholders because they are pass-through entities for tax purposes.

Growth Stocks

Growth stocks are issued by companies expected to have sustained high rates of growth in sales and earnings. These companies generally have high price/earnings (P/E) ratios and do not pay dividends. Companies such as Home Depot (ticker symbol HD) and Intel (ticker symbol INTC) grew at high double digits rates during the 1990s; the growth in these companies was curtailed shortly after that for different reasons. Home Depot faced increased competition from Lowe’s, which has newer, smaller, and more manageable stores. Intel saw sharp declines in its sales because of reductions in capital equipment spending by business, a decline in computer replacement sales by consumers, and increased competition from Advanced Micro Devices. Nevertheless, Intel still managed to keep its gross profit margins above 50 percent for most quarters during the first half of the 2000 decade.

An indication that these two companies have passed through their sustained high-growth periods is that they no longer retain all their earnings. Both pay out small amounts of their earnings in dividends. In addition, because of their leadership positions in their respective industries, they also could be classified as bluechip companies. Most growth companies pay no dividends, such as Cisco Systems (ticker symbol CSCO), which saw annual sales growth in the 30 to 50 percent range during the 1990’s technology boom. Cisco’s stock price soared around 130,000 percent from its initial public offering (IPO) in February 1990 to March 2000. Cisco expects growth to continue in the high single digits to low teens for revenue and earnings over the next five years. Rather than pay out their earnings in dividends, growth companies retain their earnings and reinvest them in the expansion of their businesses. Google is a good example of a growth company with a priceto- earnings ratio of 71. Investors are willing to buy Google at $404 per share, paying 71 times earnings of $5.70 per share.

Growth stocks are often referred to as high P/E ratio stocks because their greater growth prospects make investors more willing to buy them at higher prices. Investors do not receive returns in the form of dividends, so they buy these stocks for their potential capital appreciation.

Value Stocks

Value stocks are stocks that have lower prices relative to their fundamental values (growth in sales and earnings). Value stocks tend to have low P/E ratios, low price-to-book ratios, low price-to-sales ratios, and high dividend yields, and they also may be out of favor with investors. One reason might be disappointing quarterly earnings. For example, at the end of the economic expansion period, auto companies trade at lower P/E ratios than the stocks of other companies because investors’ expectations for the companies’ growth prospects are low. Because investors have relatively low expectations for the immediate growth of these companies, their stocks trade at lower prices relative to their earnings and dividends. Patient investors with longer time horizons are willing to purchase these stocks and wait for their prospective earnings to increase.

Table 2–5 compares some of the characteristics of growth stocks and value stocks. Investors are willing to pay 71 times earnings for Google, Inc., because of its potential future sales and earnings growth. Cisco had similar growth rates to Google in the late 1990s, but growth rates have stabilized, resulting in a decline in price from $40 per share to $19. Starbucks Corporation is also seeing a slowdown in its growth rate, resulting in a decline in its P/E ratio from 63 to 51 over the past two years. What you need to be aware of is that if growth stocks cannot sustain their high growth rates, their stock prices fall by amounts greater than the corresponding fall of value stocks.

The potential strengths of value stocks are not always evident or visible. D. R. Horton, Inc., a home builder, was trading at a low P/E ratio because of rising interest rates, which accounted for the decline in earnings growth for the next year. Patient investors with a fiveyear time horizon would find value in this stock with a projected 15 percent growth rate over the next five years. Citigroup’s stock price was supported by a dividend of $1.96 per share (close to a 4 percent yield), which protected the stock’s decline in price owing to rising interest rates. Value investors are interested in stocks whose prices are trading at less than their intrinsic value and are willing to buy stocks of companies experiencing temporary setbacks in the hope that they will overcome their earnings and asset valuation setbacks. Table 2–6 shows how you can use the Internet to find value and growth stocks.

Table 2-5
Characteristics of Growth and Value Stocks

Cyclical Stocks

Cyclical stock prices move with the economy. Cyclical stocks often reach their high and low points before the respective peaks and troughs of the economy. When the economy is in recession, these stocks see a decline in sales and earnings. During periods of expansion, these stocks grow substantially in sales and earnings. Examples of cyclical stocks are stocks issued by capital equipment companies, home builders, auto companies, and companies in other sectors tied to the fortunes of the economy as a whole. The economic growth in 2005–2006 has seen the stocks of John Deere (ticker symbol DE), the farm equipment maker, and Cummins Engine (ticker symbol CMI), the diesel engine manufacturer, rise to their 52-week highs. During a recession, stocks of this type are beaten down and are considered value stocks for patient investors who are willing to buy them and hold them until the next economic turnaround. Cyclical stocks appeal to investors who like to trade actively by moving in and out of stocks as the economy moves through its cycle.

Table 2-6
How to Use the Internet to Find Value and Growth Stocks
Use a stock screener on www.finance.yahoo.com or www.moneycentral.msn.com to see a list of some current growth and value stocks. For growth stocks, enter higher P/E ratios and higher earnings per share growth estimates. For value stocks, enter lower P/E ratios and lower earnings per share growth estimates.

Defensive Stocks

Defensive stocks are the stocks of companies that tend to hold their price levels when the economy declines. Generally, these stocks resist downturns in the economy because these companies produce necessary goods (food, beverages, and pharmaceutical products). However, during periods of economic expansion, defensive stocks move up more slowly than other types of stocks. Defensive stocks are the stocks of companies whose prices are expected to remain stable or do well when the economy declines because they are immune to changes in the economy and are not affected by downturns in the business cycle. Examples of stocks of this type are drug companies, food and beverage companies, utility companies, consumer goods companies, and even auto parts manufacturers. In a recession, people generally wait to replace their cars and are more likely to spend money to repair them. Similarly, during periods of inflation, the prices of gold stocks tend to rise. Drug companies have predictable earnings, which puts them in the defensive category and also the growth stock category because of their pipelines of new drugs. If the economy goes into a deflationary environment, the stocks of some supermarket chains, which are viewed as defensive-type stocks, might fall out of this category because supermarket chains generally have low profit margins and cannot pass higher prices on to consumers. Many investors buy defensive stocks ahead of an economic downturn and hold them until better economic times.

Speculative Stocks

Speculative stocks have the potential for above-average returns, but they also carry above-average risk of loss if the company does poorly or goes bankrupt. Speculative stocks are stocks issued by companies that have a small probability for large increases in the prices of their stocks. These companies do not have earnings records and are considered to have a high degree of risk. In other words, these companies are quite likely to incur losses and not as likely to experience profits, so they have a higher possibility of larger price gains or losses than other types of stocks. Speculative stocks are more volatile than the other stock types.

Speculative stocks are often issued by new companies with promising ideas that are in the development stages. With oil above $70 per barrel in 2006, the stocks of many alternative energy companies with low sales and no earnings rose to high prices with investors speculating on their potential relevance in providing alternative sources of energy.

The requisite quality for buying speculative stocks, because of their high risk, is a strong stomach—you have to be able to sleep well at night under any circumstances. These stocks deliver either large capital gains or large capital losses.

Penny Stocks

Penny stocks are speculative, low-priced stocks that generally trade on the over-the-counter markets and pink sheets. [The pink sheets provide the listings, the quotes (bid and ask) of the lower-priced, thinly traded over-the-counter domestic stocks and foreign stocks.] Penny stocks are low-priced stocks ($1 or less) in companies whose future operations are in doubt. “Boiler room” (illegal) sales operators have promoted some penny stocks by cold calling unsophisticated investors on the telephone to stress how much money they could make by buying these low-priced stocks. To paraphrase the old saying, “There are no free lunches on Wall Street.” If a share is trading at 25 cents per share, it is probably trading at its fair value and for good reason. If the stock goes up to 50 cents, an investor makes a 100 percent return; if the company goes out of business, the investor loses his or her entire investment.

Foreign Stocks

Foreign stocks are stocks issued by companies outside the country of origin. Although the U.S. stock markets still account for the largest market capitalization of all the stock markets in the world, the foreign stock markets are growing in market share. Foreign stocks provide you with the opportunity to earn greater returns and to diversify your portfolio. You can buy foreign stocks directly in the foreign markets or buy American depository receipts of the stocks of foreign companies. An American depository receipt (ADR) is a negotiable receipt on stocks held in custody abroad. These receipts are traded in place of foreign stocks. Many large foreign companies trade as ADRs on the U.S. markets (New York Stock Exchange and the over-the-counter market). Table 2–7 provides an example of some of the foreign stocks trading as ADRs on the U.S. markets.

Large-, Medium-, and Small-Cap Stocks

Stocks also can be classified by size: small-cap stocks, medium-cap stocks, and large-cap stocks. Cap is short for “market capitalization,” which is the market value of a company (determined by multiplying the company’s stock price in the market by the number of outstanding shares). Market capitalization changes all the time, and although the definitions include a market value for each category, these market value threshold classifications also change over time. Below are the differentiating values for the groupings of companies by size:
Large-cap stocks are the stocks of large companies with considerable earnings and large amounts of common stock outstanding. This group has a market capitalization of greater than $5 billion. Large-cap stocks represent the companies in the Dow Jones Industrial Average and the S&P 500 Index. These large-cap companies account for more than half the total value of the U.S. equity markets. These are blue-chip, established companies that can be either growth or value companies. Some examples are Intel, Microsoft, IBM, General Motors, ExxonMobil, and many other large leading companies in their respective industries.
Medium-cap stocks are the stocks of medium-sized companies with market capitalizations of between $1 billion and $5 billion. Medium-cap companies have the safety net of having significant assets in terms of their capitalization, but they also may not be so well known to average investors. Some examples of well-known medium-cap companies are Tyson Foods, Outback Steakhouse, Starbucks, and Borders.
Small-cap stocks are the stocks of small-sized companies with a market capitalization of less than $1 billion. Small-cap companies generally are not household names, although they offer the most attractive return opportunities. This group of stocks has, according to studies, outperformed the large-cap stocks over long periods. Small-cap stock prices tend to be more volatile than those of large- and medium-cap companies because of their greater exposure to risk. Some small-cap companies are potentially the Intels and Microsofts of tomorrow. Many small-cap companies go out of business, whereas others are successful and grow to become medium- and large-cap companies. Because small-cap stocks are riskier investments, you should diversify your holdings of them to reduce your overall risk of loss.

Figure 2–1 shows how small-cap and foreign stocks outperformed medium- and large-cap stocks for the year ended March 31, 2006. For the same-period, medium-cap growth stocks outperformed medium-cap value stocks. The strategies for which types of stocks to choose are discussed in Chapters 10, 11, and 12.

What also becomes apparent from these classifications of common stock types is that a company can have multiple classifications. The pharmaceutical company Johnson & Johnson can be classified as a blue-chip stock, a growth stock, a large cap-stock, and a defensive stock. These classifications are useful when you plan your portfolio to determine which types of stocks you want to own and the percentage of each that you want to hold in your portfolio.

Figure 2-1
Total Returns of the Russell 2000 Index (Small-Cap), S&P 400 Index (Medium-Cap), S&P 500 Index (Large-Cap), MSCI EAFE Index (Foreign Stocks), Medium-Cap Value and Medium-Cap Growth for the Year Ended March 31, 2006.

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