Types of Stocks
Investors have different objectives, such as growth or income, and different risk profiles and different investment horizons. Hence, investors seek stocks that satisfy their objectives. To ease choosing, stocks are categorized according to their investment characteristics. The most common categories are listed below.
Blue-chip stocks are stocks of large, stable companies with a long history of stable earnings and dividends, and are typified by the stocks composing the Dow Jones Industrial Average, including General Electric, IBM, Microsoft, and Pfizer. Because of their large size, there is less potential for high growth, so most of the return of these stocks is in the form of dividends. However, capital gains can be earned from these stocks if they are bought in a bear market, when stock prices are depressed overall or held for a long time. For instance, during the Great Recession ofNovember and December, 2008, and the early part of 2009, Microsoft was trading below $20 per share, whereas before this, Microsoft had been trading at around $30 per share for a long time. By mid-February 2020, the stock peaked at $185 per share.
Income stocks generate most of their returns as dividends, and the dividends — unlike the dividends of preferred stock or the interest payments of bonds — may grow continuously year after year as the companies' earnings grow. These companies have a high dividend payout ratio because there are few opportunities to invest the money in the business that would yield a higher return on stockholders' equity. Hence, many of the these companies are already very large, and are also considered blue-chip companies, such as General Electric.
Cyclical stocks cycle with the economic cycles, going up strongly when the economy is growing and declining as the economy declines. Most of these companies supply capital equipment for businesses or big ticket items, such as cars and houses, for consumers. Some examples include Alcoa, Caterpillar, and Brunswick. The best time to buy and sell these stocks is at the bottom and top of a business cycle, respectively.
Defensive stocks are stocks of companies resistant to economic cycles, and may even profit from them. When consumers and businesses cut back spending, some businesses profit, either because they offer a way to cut costs, or because they have the lowest prices. For instance, during the Great Recession oflate 2008 and early 2009, people tried to save by doing more for themselves. For instance, many people starting cutting hair for their families, or coloring their own hair to save the $200 that some beauty shops charge. This increased business for manufacturers of hair cutters and coloring kits. Auto repair shops do better, because people cut back on the purchase of new cars, but spend more for maintenance and repairs for their older vehicles. And while most retailers were hurting significantly during the Great Recession, Wal-Mart was one of the few that actually thrived, since Wal-Mart is recognized as providing lower prices than other retailers.
Growth stocks are stocks of companies that reinvest most of their earnings into their businesses, because it can yield a higher return on stockholders' equity, and ultimately, a higher return to stockholders, in the form of capital gains, than if the money were paid out as dividends. Typically, these companies have high P/E ratios because investors expect high growth rates. Note, however, that growth stocks are risky. If a growth-oriented company doesn't grow as fast as anticipated, then its price will drop as investors lower its future prospects, so the P/E ratio declines. So even if earnings remain stable, the stock price will decline.
Another risk is bear markets — growth stocks tend to decline much more than blue-chips or income stocks in a declining market, because investors become pessimistic, and will sell their stocks, especially those paying no dividends.
One of the main benefits of growth stocks is that capital gains, especially long-term capital gains where the stock is held for at least 1 year, are generally taxed at a lower rate than dividends, which are taxed as ordinary income.
Tech stocks are the stocks of technology companies, which make computer equipment, communication devices, and other technological devices. Most tech stocks are listed on NASDAQ. The stocks of most tech companies are either considered growth stock or speculative stock; some are considered blue-chip, such as Intel or Microsoft. However, tech companies are exposed to significant risk, because research and development efforts are hard to evaluate, and since technology is continually evolving, it can quickly change the fortunes of many companies, especially when current products are displaced by new products.
Speculative stocks are stocks of companies with little or no earnings, or widely varying earnings, but hold great potential for appreciation because they are tapping into a new market, are operating under new management, have the potential of becoming a monopoly, or are developing a potentially very lucrative product that could cause the stock price to zoom upward if the company is successful. Many Internet companies were considered speculative investments. During the stock market bubble of the latter half of the 1990's, many of these stocks had ridiculous market capitalizations, and yet, many of them had virtually no earnings, and many, if not most, have since then, imploded. A few, such as Amazon, have grown to become major corporations. Other tech companies, such as Facebook, have become de facto monopolies, allowing them to earn very high profit margins, which is reflected in their stock prices.
Many speculative stocks are traded frequently by investors — or some would say, gamblers — in the hope of making a profit by timing the market, since speculative stocks range wildly in price as their perceived prospects constantly change.
Large-Cap, Mid-Cap, and Small-Cap Stocks
Stocks can also be categorized by their market capitalization, or market cap.
Market Capitalization = Stock Price × Number of Stocks Outstanding
While the divisions are indistinct, and will depend on inflation, a large-cap company has a market cap exceeding $5 billion; a mid-cap company, $1 - $5 billion, and small-cap companies are valued at less than $1 billion. Many of these companies can be found by looking at the components of the various indexes, such as the Russell Indexes.
Large-cap stocks consist of the blue-chip, income, defensive, and cyclical stocks, since large companies have little potential for growth. Capital gains can be earned, however, by buying these stocks at the bottom of a business cycle and selling them as the economy reaches full speed, or by holding them for a long time. Large-cap stocks have the best price stability and the least risk.
Mid-cap stocks are composed of most of the categories listed here, since their market caps range from the top of the small-cap market to the bottom of the large-cap market. A particular kind of mid-cap stock are the baby blue-chip stocks, which are stocks of companies that, like the blue-chip companies, have consistent profit growth and stability, and low levels of debt, but are smaller in size than the large-cap blue-chips.
Small-cap stocks are small companies with the greatest potential for growth — hence, most of these stocks are growth or speculative stocks, and most tech stocks are also in this category, since many tech companies specialize in a narrow niche of the market, or they were started to develop a new product or service, such as the many Internet companies that sprouted during the stock market bubble. Sometimes, the small-cap stocks are distinguished from the even smaller micro-cap stocks, such as can be found in the Russell Microcap Index. Note that even the micro-cap stocks include only those stocks listed on major exchanges — they do not include OTC bulletin board securities or pink sheet stocks, which do not satisfy the requirements to be listed on a major exchange.
Small-cap stocks tend to do better than other stocks at the beginning of an economic expansion, unless their growth is constrained by the availability of credit, since they rely more on bank financing than larger companies that can sell bonds directly to the market.