In the past, the term "widows and orphans" was used to describe stocks with a relatively high degree of safety and dividend income. Because they had relatively minimal risk and provided income to feed the family, these kinds of stocks were literally thought to be the only investments suitable for widows and orphans. The term is noteworthy because it was generally used during market bottoms, but today it means something different. (Explore arguments for and against company dividend policy, and learn how companies determine how much to pay out, in How and Why Do Companies Pay Dividends?)
History of the Stock
A widow-and-orphan stock was the blue chip stock of its day: the stock of a large well-known firm that was thought to have an unassailable market leadership position and that paid a "good" dividend. This term was generally applied to utility stocks (electric, gas and telephones). Utilities are often referred to as widow-and-orphan stocks because of their monopoly (or, if you prefer, government-mandated market leadership) and dividend yield. Banks were excluded from this class as the result of their involvement in the bubble and crash of 1929. It was not until several years after the government-instituted regulations like the Glass-Steagall Act, which separated investment banking and "regular" commercial banking, that "widows and orphans" was again applied to commercial banks. Depending on the business cycle, the term was also applied to railroad and auto stocks.
The AT&T Example
While the need for safety and income of widows and orphans has not changed, the markets and companies did. Stocks that were once viewed as a safe haven for very risk-averse investors changed either because the company's business strategy changed or the market changed. A good example is AT&T. (Stock ratings are both loved and reviled. Find out why they deserve equal measures of both, in Stock Ratings: The Good, The Bad And The Ugly.)
Despite many challenges, AT&T remained an archetypal widow-and-orphan stock for a long time. To use current terminology, it was the first to market and dominate its competitors until it became a de-facto monopoly. But times changed, and in the 1970s the government forced AT&T to break itself up into the Baby Bells. The breakup created competition, but AT&T continued to be viewed as a widow-and-orphan stock because, based upon its market position and dividend, it was perceived as a relatively safe investment.
In the late 1990s, AT&T changed and was no longer a widow-and-orphan stock, although many did not realize this. The change was wrought by the combination of a significant market transformation and a modification in the company's strategy. In the dotcom market, "telephone" and "telecommunications" became "telcos" as the phone companies morphed into new-age Internet stocks. The combination of government deregulation and technological advances increased competition, and the number of LECs, CLECs and telcos increased as entrepreneurs entered the market to provide commodity communication services. All of this threatened AT&T's dominant position.
In response to the change in the marketplace, AT&T changed. Management decided that it had to modify its strategy for the company to survive. They made acquisitions that altered the basic nature of the company, most notably the acquisition of Telecommunications Inc. (TCI). The acquisition of TCI can be viewed as the beginning of the end because it signaled that AT&T was no longer "your father's phone company" but an Internet firm focusing on the convergence of telco and cable services.
This change, if noted, went largely unreported. After all, who wanted safety in the late 1990s? Investors wanted dotcoms, not widow-and-orphan stocks, because all stocks rose at 20% per year, and AT&T was no exception. Despite the change from a safe utility to a highly-risky dotcom, AT&T was still viewed as a safe stock by many long-time holders. But today, few would call AT&T a widow-and-orphan stock. (Find out how these Wall Street high-rollers landed themselves in hot water, in 4 History-Making Wall Street Crooks.)
Reflecting the Times
Usage of the term "widows and orphans" seems to mirror the market. Ignored during bull markets and resurfacing in bear markets, the term regained usage during the 1970s, following the "Nifty 50" bull market of the 1960s. While these blue-chip stocks may have suffered from the economic downturn, their reliable dividend was enough to earn them the title of widow-and-orphan stock. Investors could, despite the business risk, find some degree of safety in the dividend income.
But this time may be different. Historically, widow-and-orphan stocks provided investors a safe harbor from business risk. Today investors seek refuge from an additional menace: credibility risk. This risk results from the frequent reported occurrences of corporate executives using creative accounting to cook the books, a technique these executives use to achieve profit goals and "earn" their big bonuses. Even if there are companies that seem to have credibility, can an investor ever be sure? Many of the respected big-cap stocks in the late 1990s are now discredited in retrospect, and their restated operating results almost make it seem like the economic boom was really a result of creative accounting. How can any stock be called safe enough for widows and orphans if there is the risk that the books are being cooked?
Perhaps it is time to redefine the terms "widows" and "orphans". Individual investors have been "widowed" by Wall Street, which, by following only big-cap, highly liquid stocks, has shifted its focus to serving the needs of institutional investors. "Orphan" stocks now are small-cap stocks (under $500 million in market capitalization) that have been abandoned by Wall Street, not because they are bad investments, but because they do not provide investment banking opportunities. Many of these orphan stocks are good investments because they have solid balance sheets, growing earnings, and sometimes a healthy dividend. But because Wall Street ignores them, investors remain unaware of these investment opportunities. A contemporary usage of widows and orphans may refer to small-cap stocks with solid fundamentals. These stocks pose relatively less credibility risk because management is more focused on the business rather than cooking the books.
We can reunite these widowed investors and orphaned stocks, but it will require new ways of thinking both on the part of investors and the companies of orphaned stocks. Investors must realize that they need to take more responsibility in doing their own research and looking at many sources of information (not just research reports) in order to make good investment decisions. In addition, the executives of orphaned stocks must take the initiative to get their information to the market of widows. These new channels of information distribution include webcasts and unbiased fee-based research.