D. How Investors Categorize Shares?
When you read stock market reports you will often see reporters make reference to small caps versus blue chips, growth stocks versus income shares and how the technology, financial and media sectors have performed.
These terms are all ways investors break down and analyze the stock market. Investors do this because companies that share certain characteristics often produce similar returns.
Understanding how different shares are categorized will help you analyze the stock market. It will also help you identify where there are opportunities to make money and when to cut your losses. Read more about strategies for investment.
You may also find that you like investing in a particular part of the market more than another. Many professional investors choose to focus their entire portfolio on investing in a particular part of the stock market, perhaps investing purely in smaller companies or technology stocks.
Blue Chips vs Small Caps
One of the most common ways to break down the stock market is to look at how shares have performed by size. Size in stock market terms is not measured by looking at the value of a company’s assets but by the total value of its shares in the market. This is known as the company’s capitalization, which investors often shorten to ‘market cap’ or simply its ‘cap’.
If, for example, a company has 100,000 shares and each share is worth 100p, its market cap would be £100,000. If, however, the shares fall in value to 50p, the market cap would slip to £50,000.
The biggest companies listed on a stock market are usually referred to as ‘Large caps’ and sometimes, particularly in the UK, as Blue Chips. The term blue chip comes from the colour of the highest value poker chip. The performance of large companies is represented by the FTSE 100 Index and these firms make up about 80% of the total market.
Medium sized companies, which are called mid caps make up around 18% of the market while companies with the lowest share prices are called small caps and make up around 2% of the UK market.
Investors analyze shares in these three different size categories because they often perform in a similar way. The largest companies, for example, are usually more attractive to overseas investors because their shares are traded more frequently which makes them easy to buy and sell. Big companies are also more attractive to investors during a recession because they dominate their markets and so are less likely to go bankrupt than smaller firms.
But large companies are very well researched by professional investors and this can make it harder to find ones that are undervalued. For this reason some investors prefer focusing their portfolios on medium and smaller companies where shares are less well research and you have the opportunity to make more money. Investing in smaller companies can, however, be more risky as these firms are more likely to suffer financial problems than larger companies.
Every stock market around the world is made up of a variety of companies from different industries, such as technology, media, healthcare, retailing and, financials. These are called stock market sectors.
Different sectors perform best at distinct stages of the economic cycle because the profits companies make are affected by different factors. If, for example, wages are on the way up, retail stocks will benefit as people tend to spend more. This does not however; tend to affect healthcare stocks as demand for their products is driven people’s health.
Each stock market around the world tends to be dominated by just two or three stock market sectors. The UK stock market, for example, is dominated by the performance of three market sectors: financials, oils and healthcare companies. This reflects the fact that two or three British companies in these sectors are world leaders in their field and so their market capitalization is significantly higher than other firms.
The sectors that tend to dominate the top end of the market are often not well represented at the bottom end of the market and vice versa. In the UK, for example, most of the building and construction stocks are to be found among medium and smaller companies.
Investors analyze the performance of stock market sectors and shift their portfolios to reflect which part of the market they think will do well at different times. The performance of some sectors, such as technology, media and telecommunications, can move more in tune with their counterparts overseas than other domestic companies. This is because they get a lot of their profits from overseas.
Investors, therefore, often watch what is happening in, say, the technology sector in other markets to get an idea what might happen to British technology companies. Some investors chose to focus their investments on particular global sectors rather than specific geographical markets. They are often known as ‘theme’ investors.
Growth vs Income
Another way investors break down the stock market is by whether it pays dividends or not.
Companies that don’t reinvest all the profits they make into their businesses often repay some of this money to investors through dividends. Many of these companies are in industries where demand for their products is not dictated by economic conditions, such as utilities and pharmaceutical companies. These shares are called income stocks and are often bought by older people who need income from their investments.
The dividend is used by investors to work out the yield – the gross dividend per share divided by the share price and multiplied by 100. The yield you get on a share goes up when the share price falls and goes down when the share price rises.
If, for example a company pays a dividend of 5p a share and the share price is 100p, the yield will be 5% but if the share price falls to 50p, the yield rises to 10%. Income-producing stocks are categorized by their yield as being either ‘high yielders’ or ‘low yielders’.
In theory shares that have a low yield are growing faster than companies with a high yield. Investors are prepared to accept a low yield if they think the company will be able to make bigger profits and pay larger dividends in future. But this can be a misleading assumption.
Some companies do not pay dividends at all but this does not necessarily make them bad companies. Companies that reinvest some or all of their profits back into their businesses are known as growth stocks. These shares, typically in younger industries such as technology, tend to be favoured by investors who don’t need income.
Shares from each grouping do well at different points in the economic cycle. If, for example, the economy is moving into recession, growth companies can find it harder to produce profits than income stocks, which tend to be larger, more mature businesses, so this part of the market may produce the best gains.
For this reason many companies that pay dividends are also called ‘defensive’, as they defend as they provide better protection when economic conditions are tough. Among the defensive sectors are utilities, pharmaceuticals and oils. Companies whose profits are more dependent on economic conditions, such as media, retailers and technology companies, are called ‘cyclicals’ as their fortunes wax and wane as the economy improves or deteriorates.
Cyclical vs Defensive
Cyclical stocks tend to go down in price during recessionary periods and up during economic booms. Companies in industries that are affected by general economic trends (such as automobile, heavy machinery and home building) issue cyclical stocks.
Defensive stocks are the opposite of cyclical stocks. Defensive stocks, issued by companies producing staples such as food, beverages, drugs, and insurance, typically maintain their value during recessionary periods.