The Alphabet Soup Of Stocks
If you've ever watched financial TV or read financial papers, you may have heard of classifications like cyclical, growth and income stocks. As if the difference between preferred and common stocks wasn't enough, there are now more categories to add to the confusion! In this article, we'll try to replace the confusion with some clarity and logic.
Stocks and the Business Cycle
Many stocks can be broken into categories that denote the way in which different stocks perform during various times of the year or periods of the business cycle:
- Seasonal - These companies are characterized by the different levels of demand they face throughout the year. A snow shovel manufacturer, for example, is probably not very busy in the summer. Another seasonal effect is the increase in retail sales during the holidays. But investing in seasonal stocks doesn't mean that you can automatically gain a healthy profit simply by purchasing a retail stock in the fall and selling it just after Christmas - not all seasonal stocks are guaranteed to do well, even during their peak seasons. When you analyze financial statements for a seasonal stock, you need to compare results to the same season of the previous year. (For related reading, see Analyzing Retail Stocks.)
- Non-Seasonal - These stocks are not affected by the change of seasons. Certain companies produce or sell goods that have what we call an inelastic demand curve. A good example is a peanut butter manufacturer - the demand for peanut butter is generally not affected by the weather or holidays.
- Cyclical - These companies, whose business activities intensely follow the business cycles of the economy, are always the first stocks to reflect a recession or an expansion. These companies don't necessarily intend to follow the business cycle, it just so happens that their products share this relationship with the economy. A good example of a company with cyclical stock would be a car manufacturer or an airline company. Luxury is one of the factors in the relationship between these stocks and the business cycle. Take Porsche, for example: when the economy is doing well, the sales of these fine automobiles rise. Conversely, when the economy goes into a slump, sales slow down. (To learn more, check out Cyclical Vs. Non-Cyclical Stocks and The Ups And Downs Of Investing In Cyclical Stocks.)
- Non-Cyclical - This is the opposite of a cyclical stock. Profits of a non-cyclical stock do not change readily with the business cycle. These are companies that provide us with essentials, such as healthcare and food. Also referred to as defensive stocks, these stocks don't rely on the economic environment for increased sales. A perfect example is the diaper industry: regardless of whether the economy is busting or booming, parents have to buy diapers for their babies. (To learn more, read Guard Your Portfolio With Defensive Stocks.)
Adding to the confusion, stocks are also classified according to their type of dividend payout schemes. Now remember, this is separate from what we have already discussed. Dividend payouts have little to do with the seasonal demands a company faces; instead, they are determined by each company's individual policies and objectives.
Finally, the financial industry uses many slang terms to describe and categorize stocks. These terms aren't always intuitive, but they do have their place in the financial world. Here are some of the many terms used to characterize stocks:
- Blue Chip – These are companies that are cream-of-the-crop, old-school and everlasting. Blue chips tend to be market mammoths, and have proven their ability to survive through both good times and bad. The term comes from poker, where blue chips are the ones with the highest value. These companies are generally expensive to purchase but can be safe bets. General Electric (NYSE:GE), Wal-Mart (NYSE:WMT) and IBM (NYSE:IBM) have all established themselves as blue chips.
- Penny Stock - The term "penny stock" is used to denote stocks that trade for less than a dollar, but can also refer to stocks that are considered very speculative. These stocks are generally new to the market, with no reputation or history to fall back on. Penny stocks present the possibility of large gains or losses. (For related reading, check out Spot Hotshot Penny Stocks.)
- Bo Derek – This is a term created by traders in the late '70s to describe the perfect stock. Back then, actress Bo Derek was considered "the perfect 10". This slang term might be a little dated for a new generation of investors, as Bo Derek was famous in another era.
|Watch: What Are Stocks?|
Now, how do these terms fit with one another you might ask? Well, next time you hear a cyclical income stock referred to as a real "Bo Derek", you'll know what it means. A stock's categorization can be varied and prone to change in different situations. Stocks that were once speculative may become blue chip, cyclical stocks can become non-cyclical due to some widespread economic changes and seasonal stocks may reduce their exposure to seasonal pressures by exporting goods. Changing times mean that dynamic companies will change their visions and goals. The important thing is to not only remember what category a stock falls under, but also how it compares to other stocks of the same group.