Classification of Stocks

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Dec 08, 2006
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Stocks are often classified based on the type of company it is, the companys value, or in some cases the level of return that is expected from the company. Some companies grow faster than others, while some have reached what they perceive as their peak and dont think they can handle more growth. In some cases, management just might be content with the level of business that theyve achieved, thus stalling to make moves to gain further business.

Before investing in a particular company, it is very important to get to know the company on a personal level and find out what the companys goals and objectives are for the short and long term. Some companys are growth minded, while some are defensive minded and operate in services that are always needed such as food.

In order to prosper in the world of stock investing, a person must have a clear understanding of what they are doing, or they shouldnt be doing it at all. Stocks can be a very risky investment, depending on the level of knowledge held by the person(s) making the investment decisions. So learn all you can, and as I quoted Rev Run in the real estate chapter, choose wisely. Below is a list of classifications that I find important to know.

Blue Chip Stocks

Blue chip stocks represent the largest companies in the world such as Wal-Mart, American Express, General Motors, and Home Depot. These companies usually have very high earnings year after year, and have a reputation of stability and exceptional corporate management.

These companies have great financial strength, and often share the profits of the business on a quarterly basis. These companies arent as concerned with growth, because due to their business model, the more people that are born, creates automatic business for a lot of these companies.

Because of the financial strength of most blue chips, they generally make for good investments year around, as long as the company that you are investing in, shares your personal goals and objectives. If you are looking to invest in a company that will grow at a rapid pace, and a company tells you that they are maintaining their current size as they cant handle more business right now, then this is not the company for you as they dont share your current objectives.

And for you information, in case you have any doubt, yes, the Dow Jones Industrial Average that I spoke of earlier in the chapter is composed of 30 blue chip companies.

Growth Stocks

Growth stocks represent companies whose sales and profits are growing faster then the rest of the economy or their individual sector for that matter. These companies are usually very aggressive and are actively acquiring other companies to help them achieve their growth goals.

These companies usually have a very aggressive marketing plan, and focus heavily on branding their name, which ultimately gets their product inside of our homes. These companies may be blue chips at the same time, if they are unhappy with their position and have turned growth minded, but usually growth stocks are of companies that have yet made a strong dominating mark in their industry.

Growth stocks usually dont pay dividends (share profits) to shareholders during the growth stages of the company, as they retain the majority of company profits, as they are used to grow the company with, which can often mean acquiring (buying) other companies.

So as I said before, if you are considering investing in stocks, get to know the company on a personal level before you invest in it, because their company goals may be the exact opposite of your personal investment goals. If you are looking for a company that will pay you dividends (company profits) every quarter, then a growth stock is not what you are looking for.

Defensive Stocks

Defensive stocks are companies that are generally stable all year around as they are companies that provide important goods and services that are used in good as well as bad economic times. These would include shares of such businesses as electric companies, food suppliers, tobacco companies, and soda companies like Coca Cola and General Electric.

These companies will usually hold their own (market position) in the worst of economic times, such as a downturn or recession, thus making good investments during business cycles where other investments are plunging, or declining rapidly in value.

Income Stocks

Income stocks are generally some of my favorite stocks as they offer above average dividend (profit) payments to their shareholders. These companies are usually very stable, and have gained a large market share, as they can afford to heavily reward their shareholders.

Income stocks are usually very attractive to retired people that depend on the consistent dividend payments every quarter. These are companies that are usually comfortable and content with their current market position and have focused on maintaining their current business, versus trying to gain new business. This is not always the case but generally it is.

Cyclical Stocks

Cyclical stocks are stocks of companies whose sales and profits generally fluctuate (move up & down) depending on the business cycle or condition of the economy. For example, during bad economic times, cyclical stock prices decline and in good economic times their earnings and stock price increase.

Although cyclical stocks can be used to maximize profits in recovering and expanding economic times, Im not a fan of high volatility. In times of prolonging economic hardship, these companys stock prices generally continue to decrease and sometimes these companys fall into bankruptcy and loose their market position all together.

Large Cap Stocks

Large cap stocks are generally blue ship companies that are powerhouse businesses and have a large piece of the market share. This is not always the case however, as some large cap companies have negative earnings (losses instead of profits) and declining sales.

This is possible because, unlike blue chip companies that get their name from being stable and proven companies, a large cap company is just a company with market capitalization of over $10 billion. The market capitalization of a company is determined by multiplying the companys stock price by the number of shares outstanding (shares issued to the public).

During the period right before the stock bubble burst is a good example of when many companies didnt even have revenues, but because of an inflated stock price were labeled as large cap companies. Of course you got to earn the title of being a blue chip company with long term sales and profits.

Mid Cap Stocks

A mid cap company is a company with a market capitalization of greater than $2 billion, but less the $10 billion. These companies are usually growth companies that are on their way to being large cap, and hopefully blue chip companies.

A mid cap stock may be a good investment depending on your investment goals, as a mid cap stock can possibly be a growth or income company depending on their business philosophy.

Generally a mid cap company will not pay any dividends as they are using all of the companys profits to grow and expand their current level of business. This is usually okay with their share holders as they invested for growth and not for dividends, unless they invested without knowing what they invested in.

Small Cap Stocks

Small cap stocks are stocks of companies that have less than $2 billion in market capitalization. These are usually growth companies with very aggressive marketing plans, as theyre in a position to either sink or swim.

Small cap companies rarely ever pay any dividends, as they generally need every dollar that they can get to help either expand the business, or in many scenarios to stay afloat. Many small cap companies go out of business before making it out of the small cap category, which makes this a very critical stage in the life of the business.

No matter what your goals are, it is very important to know exactly what business cycle you are in, as well as the detailed business profile of the company that you are considering investing in. It is very important to know exactly what you are doing before you start doing it.

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<img src=",0,0,75,75_.jpg" align="right"> Charlie Tian, Ph.D., is the founder of GuruFocus. You can now order his book <a href="">Invest Like a Guru</a> on Amazon.