Part of being a great investor is to be able to efficiently read and absorb financial news and articles on a daily basis. So, this week in Knowledge Corner we will cover some of the most common stock classifications that are widely used in stock market news coverage.
Blue-chip stocks is what we call shares of companies that are well known and established nationally. They have a history of paying dividends to their shareholders and reporting a steady profit growth over several years. In normal market conditions, they are relatively safe and offer a smooth ride for their investors. Blue-chip stocks are often priced high relative to their dividend yields because investors don’t mind paying extra for the low volatility. On the U.S. stock markets, the index that contains the most blue-chip stocks is the Dow Jones Industrial Average. Examples if traditional blue-chip stocks are: General Motors (GM), International Business Machines (IBM) and General Electric (GE). These companies have a long history of producing steady returns to investors.
These are stocks of companies that are very sensitive to the business cycle. The main characteristic of cyclical stocks is heavy fluctuation in correlation to macro economical effects. Their value decrease as the economy weakens and it increases as the economy strengthens. Due to this volatility, they are riskier than blue-chip stocks. Although, still more predictable than a lot of other stocks as business cycles have many well studied indicators. Some examples of cyclical stocks are: Caterpillar (CAT), Honeywell (HON) and Joy Global (JOY). These companies are dependent on high economic spending and output and a recessionary economic period will reflect poorly on the prices of these stocks.
These are stocks which prices remain relatively stable through ups and downs of the economy. The demand of the products these companies offer usually stay steady in any economic environment and thus its earnings are usually constant through business cycles. These stocks can therefore be considered safer than cyclical stocks. Examples of defensive stocks are: Unilever (UL), Wal-Mart Stores (WMT) and Procter & Gamble (PG). These companies tend to go well during recessionary periods because people still have a demand for their products whether things go well financially or not.
These are companies that have shown consistent earnings and profits coupled with a growing, or at least steady, dividend payout ratio that is usually higher than the rest of the market.
A simple way of explaining a value stock is to call it a “bargain” stock. Basically, the stock is selling for less than what it is estimated to be worth relative to its fundamental metrics. It is undervalued. Typically, you can discover a value stock by finding a stock that has a low price-to-earnings ratio (PE ratio) and a high dividend yield.
Companies that may not yet have declared big profits but that are expected to grow substantially in the coming future. Growth companies usually offer lower dividend yields than other companies in their peer group. These companies typically have high PE ratios.
Penny stocks are shares that are traded for less than $5 per share. These are companies that are usually not profitable and often have limited cash and resources. They also trade in very low volumes. With those characteristics, it’s not difficult to figure out that these are very risky investments.
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