Investment types

3)- Classification of industries by investors

Most investment services (such as Standard & Poor, Moody's, Value Line discussed in Chapter 1 Section D-2c) put stocks in four general groups: manufacture, transportation, utilities and financial. Dow Jones has only three groups: industrial, transportation and utilities. While this type of breakdown roughly corresponds to major types of economic activity, it does not serve the needs of investors who prefer to look at industries according to investment goal each industry best serves. Consequently, the investment community puts stocks in five categories: growth, cyclical, durable, income and defensive. In addition, cyclical stocks are sometimes divided into durable and non-durable, and two other classifications pay attention to companies of small size or in special difficult situations (i.e. speculative stocks). The justification for these labels will be further explored in the following sections which deal with analysis of growth rates and relation to the business cycle. For now, let's look at each designation on the basis of what it can do for the investor.

a)-Growth stocks are naturally expected to provide a higher stock price growth rate than the overall market (see Section D-1 of this chapter). One may distinguish aggressive growth stocks from moderate growth. The aggressive growth companies are those that do not pay dividends, may have losses and carry a high degree of risk. New technology or new market entries characterize most of the products: for example, in 1999 e-commerce IPO's, and a few years earlier, software developers. The moderate growth stocks may pay dividends, but above average capitals gains are expected: for example, pharmaceuticals.

b)- Cyclical stocks experience a sharp capital appreciation when the economy is expanding, and are battered when the economy is in recession. As it will be further elaborated later in this chapter in the discussion of performance over the business cycle, there is a distinction to be made between companies in cyclical durable goods (see Section D-2), such as automobile, truck, equipment, and those in cyclical nondurable goods (see Section D-3), such as clothing, leisure and luxury goods. Investors who base their strategy on technical analysis (as introduced in Chapter 4 Section F-1 and explained in Chapter 5 Section J), will buy these stocks in good times, and dump them as soon as bad times are on the horizon; thus, causing these stock prices to be even more cyclical than the overall market. They pay attention to the relative strength of a stock which measures how much a stock outperforms an overall bullish stock market. In a bearish market, the stocks to buy are those with low relative strength, such as defensive stocks discussed below, because they go down less than the rest of the market, if at all.

c)- Income stocks are known as such because they pay steady dividends all through the business cycle (not because their rate of return is higher, it is not). They offer hardly any hope for dividends increase, and almost none for capital gain, but the lack of risk is what attracts investors (as discussed in Chapter 12 Section A-2b). Utilities are usually classified as such: water, electricity and gas companies. Utilities do experience some cyclicality because of their industrial sector demand. In addition, with recent deregulation, some utilities have entered new technology fields, or expanded their market, and they consequently became a little more growth oriented with its corollary risk.

d)- Defensive stocks are those that outperform a bear market. Companies with counter-cyclical revenues and earnings would naturally qualify as defensive stocks (see Section D-4 of this chapter). This would be the case of many service industries (such as medical care), as well as some mining companies. For instance, a gold producing company is typically looked upon as defensive investment because gold price tend to increase in recessions in light of the security gold offers (or used to offer). All companies that are little affected by the business cycle are generally also perceived as defensive. This would be the case of a food producer that pays modest dividends but whose revenues, earnings and stock price do not go down much in recessions. Investors find in these stocks a safe haven to weather out a recession or a bear market.

e)- Size classifications

In addition to the former characteristics tied to investor's expectations and state of the economy, there are distinctions based on company size: either blue-chip, mid-cap or small-cap stocks. Stocks in any one of the above five categories can grouped as small-cap or blue-chip.

Blue-chip stocks are the shares of the largest and most prestigious companies. They are those that make up the Dow Jones industrial average (discussed in Chapter 1 Section D-4). Because of their strength, they are considered by investors to have less risk even while offering better growth potential than comparable companies not included in DJIA. But because of the added investor's interest, their price may actually not be as attractive as that of their less prestigious competitors.

Small-cap (or small capitalization) stocks are those of small companies. Historically, small companies have outperformed large companies by an annual average of 6% (see Ibbotson statistics in Table T-2.1 in Chapter 2). These companies tend to be more cyclical and more vulnerable than larger companies in the same industry. The growth of NASDAQ in late 1990's is proof of their success. Risk is naturally higher (because smaller companies have less financial strength), and these stocks are attractive only to investors that can adequately diversify. Several studies have suggested that risk was not the major reason for the abnormal return of these stocks, but the neglect of investors. Large companies are subjected to the scrutiny of the media and investment information services. For small companies, the financial analysis has to be done by the investor him/herself. Because this analysis is difficult and uncertain, most investors will neglect these stocks in favor of extensively reviewed larger company stocks. Some investment services do provide information and analysis of some mid-cap stocks (which are naturally medium size companies). More will be said about small and medium size companies in the discussion of market composition.

f)- Speculative stocks

Finally, there are speculative stocks which are those of companies in financial difficulties, and those of initial public offerings of small unknown companies. The risk is substantial and investors without the support of financial analytical skills should stay away from these stocks.

See review questions Q-14A3.1 through Q-14A3.18.

See research assignment R-14A3.1 and R-14A3.2.

Previous: 2-NAICS
Last modified: Jun/01/01 Next: Industry growth rates