3 Different Ways to Classify Stocks – Sector or Industry, Earnings Growth – Value Stocks, Income Stocks, Growth Stocks, Size
There are different ways in which people classify and identify stocks.
1) Classifying Stocks by Sector or Industry
In fact, stocks are often identified by their sector or industry.
A sector is a group of companies that loosely belongs to the same industry and provides similar products or services. Examples of stock sectors include airlines, software, chemicals, oil, retail, automobiles, and pharmaceuticals. Understanding sectors is important if you want to make money in the stock market. The reason is simple: No matter how the market is doing and no matter what the condition of the economy, there are always sectors that are doing well and sectors that are struggling.
For example, during bear markets, the computer and technology sectors and anything related to the Internet (i.e., growth stocks) often get hit the hardest. Many pros shift their money out of the weak sectors and move into “recession-proof” sectors such as food, pharmaceuticals, beverages, and household goods (i.e., consumer staples). Even in a recession, people must eat, drink, take medicines, and buy household goods such as tissue and toilet paper.
Some professional traders shift their money into and out of sectors every day. Once they identify the strongest sectors for the day using charts, they pick what they think is the strongest stock in that sector.
Like anything connected to the stock market, successfully shifting into and out of sectors sounds easier to accomplish than it is in real life, and is best left to the pros. It’s always easier to look in the rearview mirror to figure out what sectors were most profitable. Nevertheless, it’s worth taking the time to understand and identify the various sectors and to be aware of which sectors are strong and which are weak.
2) Classifying Stocks by Earnings Growth – value, income, and growth
In addition to identifying stocks by sectors, you can also classify stocks by how much their earnings have grown in the past, and thus are expected to grow in the future. The three main types of stocks are value, income, and growth.
a) Value Stocks: Stocks That Sell for Less than They’re Worth
Value stocks are shares of companies that are selling at a reasonable price compared with their true worth, or value. The trick, of course, is determining what a company is really worth. The goal is to find solid stocks that are undervalued. Some low-priced stocks that seem like bargains might be costly, while a high-priced stock might actually be a bargain. Just knowing the price of a stock isn’t enough. You also have to know what it’s really worth. To paraphrase Oscar Wilde, too many people know the price of everything but the value of nothing.
Value stocks are often those of old-fashioned companies, such as insurance companies, retail stores, and certain banks, that are likely to increase in price in the future. It takes a lot of research to find a company whose price is a bargain compared to its value. Investors who are attracted to value stocks use a number of fundamental tools to find these bargain stocks.
b) Income Stocks: A Conservative Way to Make Money
Income stocks include shares of corporations that give money back to shareholders in the form of dividends(some people call these stocks dividend stocks). Some investors, usually those who don’t like taking risks, like dividends because they provide a cash return on their investment dollars. Investors who are near retirement are also attracted to income stocks because they plan to live off the income. This is another way for investors to share in the company’s profits.
Stocks that pay a regular dividend tend to be less volatile (the price does not rise or fall as quickly) than others, which is fine with the conservative investors who buy income stocks. Another advantage is that the dividends reduce the loss if the stock price goes down. Income stocks can be in any sector, but typically they are in industries such as energy, utilities, and natural resources.
There are also a few disadvantages to buying income stocks. First, dividends are considered taxable income, so you have to report the income to the IRS. Second, if the company doesn’t raise its dividend each year—and many don’t—inflation can cut into your returns. Finally, income stocks can fall, even if not as quickly as other stocks. Just because you own stock in a so-called conservative company doesn’t mean that you will be protected against losing money if the stock market falls.
c) Growth Stocks: Volatile Stocks Fueled by Strong Earnings
Growth stocks are the stocks of companies that consistently grow their earnings year after year. They are expected to grow faster than the competition, and the stock price reflects that expectation. Strong earnings, and the acceleration of those earnings, make growth stocks attractive for investors. These stocks are often in high-tech industries.
Sometimes, the price of growth stocks can be extremely high with a high price-to-earnings ratio (P/E), especially when the company’s earnings aren’t spectacular. This is because growth investors believe that the corporation will earn money in the future so they are willing to invest now. However, even one disappointing earnings report can cause the stock to decline quickly.
Because growth stocks can be volatile, they can be risky investments. These are ideal for short-term traders who want to play for a quick profit, or for long-term investors who believe in the company and its business model. The volatility, however, is unnerving for many.
3) Classifying Stocks by Size
You can also classify stocks by size. The market capitalization (or market cap) of a stock tells you how large the corporation is. To calculate market cap, multiply the number of outstanding shares (which is easily found online) by the current stock price. For example, a large corporation with one billion outstanding shares and a stock price of $50 has a market cap of $50 billion.
Some people will invest only in large-cap stocks (those of large corporations worth over $10 billion), including the stocks of corporations such as Coca-Cola, Home Depot, and Johnson & Johnson. Why? They feel that the stocks of these corporations are safer to own and will not tumble in price. (Note: Thanks to companies like Lehman Brothers and Enron, we know that even large, well-known corporations can go bankrupt.)
Other investors are attracted to mid-cap stocks (those of medium-sized corporations worth between $2 and $10 billion), while still others invest in small-cap or microcap stocks (those of small corporations worth between $300 million and $2 billion) because their price often moves quickly.
It’s not easy for large-cap stocks to double or triple in price. For example, for the stock price of a large-cap stock to double from $50 to $100, the company would have to increase in value from $100 billion to $200 billion—not impossible, but extremely difficult. Some investors prefer nimble small-cap stocks because there is a better chance that they will double or triple in value. On the other hand, smaller-cap stocks come with a higher risk that the business will fail. Buying stock in very small companies is an example of taking more risk to seek a higher profit.