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, now more categories are adding 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 how they perform during various times of the year or business cycle periods:
- Seasonal - These companies are characterized by the different demand levels 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 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.
- 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 economy's business cycles, 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, sales of these fine automobiles rise. Conversely, when the economy goes into a slump, sales slow down.
- 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 health care 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.
Stocks and Dividends
Adding to the confusion, stocks are also classified according to their type of dividend payout schemes. Note that 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.
- Growth - Growth stocks are known for their lack of dividends and rapidly increasing market prices. Defined by their tendency to grow faster than the market, these companies generally reinvest all earnings into infrastructure to maintain rapid growth, rather than directly paying out their earnings to investors. Young technology companies are often considered to be high growth, but the main characteristic of growth companies is that they believe that plowing earnings back into the research and development of new products benefits shareholders more than a dividend check every three months.
- Income - These stocks aren't (usually) growth hungry, or they've already reached their maximum growth potential. Income stocks' prices do not tend to fluctuate a great deal. However, they do pay higher-than-average dividends. An income stock's value depends on its reliability and track record in paying dividends. Generally, the longer a company has maintained dividend payments, the greater its value to investors. Historical examples of income stocks are real estate investment trusts (REITs) and utility stocks, many of which pay out annual dividends of 5% or more.
Stock Slang Terms
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 companies 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) and Walmart (NYSE:WMT) are examples of blue chips.
- Penny Stock - The term "penny stock" denotes stocks that trade for less than a dollar, but it can also refer to stocks 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.
- 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."
- Tracking Stock - Also known as "designer stock," tracking stock is a type of common stock, issued by a parent company, that tracks the performance of a particular division with no claim on the assets of the division or the parent company. Tracking stock also refers to a type of security specifically created to mirror the performance of a larger index.
The Bottom Line
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.