3.6: Types of Stocks, Growth versus Value, and Market Capitalization

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Many people mistakenly believe that all stocks are the same. This is similar to believing that all companies are the same. This is obviously untrue. Is McDonald’s similar to The New York Times? Is Kellogg’s the same as Google? Who or what is Fifth Third and what do they do? Every company is different. However, there are broad categories that we can identify. Some companies fit neatly into one category, some fit into more than one category, and some don’t fit well into any category. In this next section, we will identify and discuss the major categories of companies. Much of this material was paraphrased from Peter Lynch’s excellent and very easy-to-read book One Up On Wall Street. It is one of the two books that should be your first investment book to read. The other is A Random Walk Down Wall Street by Professor Burton Malkeil. Both are readily available at your local library. Some libraries even allow you to download them to your mobile device. (Psst. If you want to have an unfair advantage over your fellow students and your future colleagues at work, read. But since you are reading this, you already knew that, didn’t you? Lucky you!)

Blue-Chip Stocks

Blue-chip stocks are financially strong, high-quality stocks with long and stable records of earnings and dividends. They have their roots deep in the economy. Most are multinational and many earn more money outside the United States than inside the United States. They are sometimes referred to as value stocks. They are suited to conservative investors who are attracted to stocks for their growth and income opportunities but who also want stocks with downside resilience. (In this context, conservative applies only to investments, not politics.) Examples included ExxonMobil and Johnson & Johnson, companies that have been in business for over a century. Most blue-chip companies have survived many market downturns. Peter Lynch calls blue-chip stocks the stalwarts. Blue-chip stocks normally never explode on the upside but they almost never implode and dissolve into a pool of tears.

Interestingly, the term blue-chip comes from the world of gambling. Over 100 years ago, only gentlemen owned stocks. Gentlemen also went to the gambling tables. It was what a gentleman did. At the time, the blue chips were the most expensive tokens.

Income Stocks

Income stocks are the stocks of companies with long and sustained records of paying higher-than-average dividends. Income stocks are also often referred to as value stocks. These are normally slow growth companies in mature industries. Examples included utilities and banks. Investors typically choose income stocks for their dividend opportunities. Similar to blue-chip stocks, income stocks are also very popular with conservative investors looking for downside protection. Remember that the return from dividends is also positive. Unlike capital losses, there are no dividend losses. However, growth opportunities from income stocks are normally very limited. Sometimes the industry that the income stocks are situated within is actually shrinking. This has been likened to a melting ice cube. Eventually the stream of income runs dry.

Growth Stocks and the Growth versus Value Debate

Growth stocks are stocks of companies that are experiencing high rates of growth in operations and earnings. Their growth rate is typically 15% to 20% per year or higher. They are normally associated with high price-to-earnings (P/E) ratios. Usually, they pay no dividends at all or possibly a very small token amount. This is because the earnings are needed to reinvest back into the company as it grows. Their stock prices should go up but they will exhibit strong volatility.

Examples of growth companies are typically found in the current news. They are celebrities. Their photos are on the covers of all the magazines from Forbes to Vogue and GQ. They have the perfect haircuts and the bright white teeth and the well-defined abs. Money flows into these stocks and the prices often rise to unsustainable levels. When the slightest hint of their growth slowing appears, the stock prices are often punished. For the math fans reading this, growth investors often look at the second derivative (the acceleration of growth), not just the first derivative (the velocity of growth). For everyone else, please ignore the previous sentence.

The investment world loves to throw around the terms “growth” and “value.” Unfortunately, the meanings of these terms are not exact. Typically, investors often use the term “growth” to designate a high P/E stock while they use the term “value” to denote a low P/E stock. For others, “value” means there is something attractive or compelling about a stock, either from an opportunity for growth and capital appreciation or from a current or growing income perspective or maybe both growth and income. Hence, a stock with a high P/E ratio might be a great value while a stock with a low P/E ratio might not be a good value. An excellent example of this was the story of Google and GM in 2005. In January of 2005, Google was selling for around $200 with a sky-high P/E ratio while the old GM was selling for $34 with a very low P/E ratio and a huge dividend. As of Feburary 2023, Google sells for approximately $4,500, split adjusted, with a much lower P/E ratio, and the old GM stock, first renamed Liquidation Motors and then ultimately Motors Liquidation, went into bankruptcy and last sold for $0.04 in March of 2011 and is now completely worthless. Which one was the better value?

Therefore, to avoid confusion when reading, researching, or simply talking with other investors about potential stocks to invest in, always be sure which definition of value is being used.

Speculative Stocks

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” − The Intelligent Investor, Benjamin Graham

So does anyone wanna’ go buy some stock of that sure-fire high-tech startup your friend told you about? Well, before you do, take a look at the history of GoBroke, oops!, sorry, I meant GoPro (GPRO). Recently, as of February 2023, we have seen the prices of many of the high-flying growth stocks fall 50% or more. Research Meta (META, née Facebook), Netflix (NFLX), Roblox (RBLX), and Shopify (SHOP).

Cyclical Stocks

Cyclical stocks are stocks whose earnings and overall market performance are closely linked to the general state of the economy. These businesses follow the business cycle of advances and declines. The poster child for cyclical stocks are car companies. When the economy is strong, car sales soar. Everybody wants a new car! What happens when there is economic turmoil? Car sales hit the brakes and screech to a halt. Other examples include manufacturers of basic materials such as timber, steel, and chemicals. In fact, any company that makes products that are used in the manufacturing process is typically cyclical. A generation ago, the chip manufacturers were growth stocks. Now that almost every product contains at least one computer chip, the chip manufacturers have more and more become cyclical.

Defensive Stocks

The opposite of cyclical stocks are defensive stocks. Defensive stocks tend to hold their own, and even do well, when the economy starts to falter. These companies typically exhibit strong downside resilience during declines in the market. Sometimes, the prices of their stocks go up as the market goes down. The conventional reasoning for this dynamic is that momentum speculators and traders “rotate” out of their short-term, growth-oriented speculations and move to the relative safety of the defensive stocks. As with much of the conventional wisdom regarding investments, whether or not this is correct is subject to debate because no one has ever stopped to ask the millions of traders if that was their motivation. Defensive stocks are often associated with income and value stocks. Examples include food companies such as Kellogg’s and consumer staples companies such as Procter & Gamble.

Turnaround Stocks

Turnaround stocks are companies that have fallen on hard times. As a potential investor, you must judge whether or not there is the potential for a rebound. Your Humble Author normally refers to turnaround stocks as “goners.” In practice, the percentage of companies facing bankruptcy that can successfully turn themselves around is small compared to the companies that do eventually disappear. For those who love a great business story, research Lee Iacocca and Chrysler in the late 1970’s and early 1980’s. Mr. Iacocca is generally regarded as bringing Chrysler back from the brink of extinction. For you budding entrepreneurs who believe engineering a turnaround of a company is in your future, please consider reading Mr. Iacocca’s autobiography. Another successful example of a turnaround is GM, which went through bankruptcy after the Global Financial Crisis and has emerged as a much stronger company. Examples of turnaround companies to study now are AMC, GameStop, and Bed Bath and Beyond. Any predictions?

Asset Play Stocks

A company that is sitting on an asset that could be sold or spun off is called an asset play stock. Investors often must dig a bit deeper than usual to find the hidden assets in a company. A good example was JCPenney’s. Their retail business has been struggling for many years now and there were reports that they were going to head into bankruptcy. However, most people did not know that JCPenney’s had a very profitable insurance division. They were able to sell the insurance business in 2015 to help keep the company afloat. Another example is the company that owns Frito-Lay. Care to guess who they are? (Great research assignment!) Whenever we research a company, it pays for us to look under the rug and see if there are any golden nuggets hiding underneath the company’s visible face to the world.

Penny Stocks

Penny stocks are normally not to be discussed in polite company. The vast majority of them are sham corporations that are used by con artists. They live on the wrong side of the tracks in the rough part of town, namely the OTC Markets, the Bulletin Board and the Pink Sheets. Yes, every so often you will find a company that has hit on hard times and is trying to make the big time again, but that is the rare exception, not the norm. There are literally thousands of these penny stocks with names like butterfly.com and Flim-Flam, Inc. One real example was Definitive Rest which started out making mattresses but then suddenly switched to making specialty metals for the aerospace industry before disappearing from the face of the planet. Another is Deep Earth Resources which has somehow managed to stay in the same business but as of April 2022 was selling for $0.0002 per share while earnings were a stunning negative $0.0010. At least in Deep Earth’s defense, they published their earnings. Many other penny stocks don’t bother to fulfill their SEC requirements and simply wait until they are kicked off the OTC Markets before reemerging in some other incarnation. Oh, by the way, Deep Earth Resources stock is no longer being traded.

You may be thinking, “So what is the purpose of penny stocks? The purpose is to separate you from your money, pure and simple. A mass email or text or social media page will tout the wonders of this particular unknown company which has a technology that will revolutionize the world and it is only selling for 7¢ per share! They scream in ALL UPPER CAPS that it will rise to 25¢ by the end of this week so you must act NOW! So you think, “Okay, what have I got to lose?” You buy $70 or $700 worth of Bogus Enterprises. Sure enough, the next day, it rises to 10¢. Oh, my Goodness! (Or as the younger folk text one another, OMG!) You buy some more shares. Two days later, it’s now 17¢! You can’t believe your luck. You break the bank and sell all your other stocks and spend every last dime and buy as many shares as you can afford at 17¢ a share because, well, gee, I can get out tomorrow or the next day just before it hits 25¢, right? The next day, you check the price of Bogus and it is now 0.001¢. What? What happened? You have been had. You have been scammed by an age-old trick in the financial world, pump ‘n’ dump.

A bit of investment industry trivia: When you open a brokerage account, in the application process, you will be asked if you have any other brokerage accounts open. The reason for this is that often, the scammer is just one person. He or she needs to be able to make trades with themselves to make it appear that there is market activity in the penny stock they are using for the scam. The SEC is monitoring individuals with multiple accounts and watching for just such activity. For this reason, most pump ‘n’ dump schemes need to have multiple scam artists. Hence, when a pump ‘n’ dump scheme is uncovered, the individuals are also charged with conspiracy. By the way, many brokerage firms will simply not accept trades of sham penny stocks.

Deciding what exactly constitutes a penny stock is not always easy. Traditionally, when the price of a stock fell below $5, it was in danger of being labeled a penny stock. However, as we saw, a reverse split can remedy this situation with one stroke of the accountant’s pen. Identifying a penny stock can be compared to determining whether something is a work of art or not, “You know it when you see it.” Upon examination of the company’s business, their reported products, customers, and financial statements ‒ or lack thereof of these essentials ‒ it often quickly becomes evident that the company is a sham and their stock is worthless except for the perpetration of fraud.

Some people think they can outsmart the scam artists. Don’t even try. There is an old saying, “If you don’t know who the patsy is at the poker table, the patsy is you.” The scam artists are watching every trade that happens because there aren’t that many of them. Normally, the only trades were your trades and the trades that the scam artists were selling to one another to make it look as though there was normal trading going on. Dear Readers, stay away from penny stocks. Again, penny stocks should never be discussed in polite company.

Foreign Stocks

Foreign stocks, also called international stocks, are stocks that are domiciled outside the United States. For several decades, it was difficult and sometimes impossible to purchase foreign stocks directly. A potential investor needed to open a brokerage account in the country the company was domiciled and then exchange their dollars for the currency of the company. Most investors seeking to invest globally would utilize global or international mutual funds. The mutual funds have the sufficient resources and skills to trade globally.

However, many investors still wanted to invest directly in foreign companies. Many prudent, long-term investors used American Depository Receipts (ADRs) to purchase the stocks of high-quality foreign companies. A large bank or trust company would go abroad and purchase a substantial block of shares of a large multinational company based in London or Frankfurt or Tokyo. The bank or trust company would then issue dollar-denominated American Depository Receipts in New York on the New York Stock Exchange. Global Depository Receipts (GDRs) followed in the footsteps of ADRs and are traded around the world.

Due to technological advancements and competition, many brokerage firms now offer international brokerage accounts that allow investors to easily convert their dollars to foreign currencies and then trade on foreign exchanges. When converting dollars to another currency and investing abroad, one must be mindful of currency risk. Every business day, the dollar rises and falls relative to foreign currencies. In general, all other things being equal (and they never are), when the dollar strengthens, the values of your investments abroad fall. When the dollar falls, the values of your investments abroad rise. Since the Global Financial Crisis of 2008, the dollar has risen substantially. Coupled with the outsized performance of the United States stock market, this had made foreign stock investments look comparatively poor relative to the United States.

Some market professionals argue against investing abroad. One of the most famous was Jack Bogle, Founder and past CEO of Vanguard Funds. The last decade has made their argument appear strong. However, going back decades before the turmoil of 2008, the performance of the United States relative to foreign markets had been fairly even, albeit volatile. For this reason, before the last decade, many prudent, long-term investors believed it was a good strategy to be invested in both the United States and abroad. In general, diversification is a good thing and there are many great opportunities around the world. It is simply not true that all the best companies are based in the United States.

In addition, there are many who argue that at this point in time (May 2022), it is imperative that investors seek opportunities abroad. Many international stocks are inexpensive relative to their United States counterparts. At the same time, the dollar is very strong. This is a great one-two combination. Investors can use strong dollars to buy relatively cheap stocks of great companies. Time will tell if this strategy is successful compared to staying invested solely in the United States. In the interests of full disclosure, Your Humble Author is a strong advocate of global diversification. (Psst. Who is the world’s largest tire manufacturer? The world’s largest food company? The world’s largest cement company?)

Market Capitalization

When discussing stocks, many casual observers will invariably concentrate on the market price. This is unfortunate and ultimately unproductive. Prudent, long-term investors are far more interested in researching the market capitalization of a company, rather than just the price of a single share. Market capitalization represents the total value of the company. It is a simple calculation. The current price of a single share of the stock is multiplied by the number of shares outstanding. The resulting number is how much the company is worth. There are three major categories, two sub-categories, and an additional category that should never be discussed in polite company.

Table 3.6.1: Market Capitalization Categories

Category	Market Values	Sub-category (if applicable)
Large-cap	Greater than $10 billion (Some now say >$15 billion)	Mega-cap ‒ Greater than $100 billion
Mid-cap	Between $2 billion and $10 billion (Some now say between $5 or $6 billion up to $15 billion)
Small-cap	Between $100 million and $1 or $2 billion (Some now say up to $5 or $6 billion)	Micro-cap ‒ Less than $100 million

Do you remember our discussion of the various types of stock mutual funds and the three major market capitalization categories, large-cap, mid-cap, and small-cap? A playful way to remember the three major categories is to think of the large-cap companies as the Papa Bears, the mid-cap companies as the Mama Bears, and the small-cap companies as the Baby Bears. (Goldilocks is nowhere to be found in this analogy.) Large-cap companies typically have their roots deep in the economy and can withstand the inevitable economic downturns better than their mid-cap and small-cap counterparts and hence exhibit less risk than the others. Small companies are nimbler and can better take advantage of changes in the economy but are more likely to be hurt substantially when the ill economic winds blow their way. Mid-cap companies fall in between their large-cap and small-cap siblings.

The two sub-categories that are popularly discussed and researched are mega-cap and micro-cap. As the names suggest, mega-cap companies exist in that rarified air of market capitalizations in the 100’s of billions of dollars. In the past few years, a few companies have cracked the trillion-dollar mark. Micro-cap companies are very small companies that have the potential to generate outsized capital gains but are just as likely to disappear from the markets all together, often for reasons out of their control. The last category that was omitted from our table above is penny stocks. Hopefully, we have already skewered these foul reprobates of the investment community enough for you to steer far away from them.

To illustrate an example of computing market capitalization, suppose a company’s stock is selling for $20 per share. We don’t know the value of the company nor which category the company fits into without knowing how many shares are outstanding. If the number of shares outstanding were 5,000,000 (5 million), then the calculation would be $20 per share multiplied by 5,000,000 shares or $100,000,000 of market capitalization. This is a small-cap company. Stocks Worksheet #3 on the class website has some example companies and calculations for you to do. However, in practice, we investors don’t need to bother with the calculation. A simple Internet search renders the number immediately.