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 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.
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 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.
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.
Characteristics of Growth and Value 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.
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 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.
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 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.
Foreign ADR Stocks
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:
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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