Characteristics, Uses and Taxation of Investments - Common Stock: Categorization



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Categorization - while not hard and fast, there are some basic types of equities based upon certain characteristics. An understanding of these various traits is critical to the asset allocation process and satisfaction of investor suitability requirements.

    1. Blue chip - older and well established companies in their industries with the ability to pay dividends in years profitable and otherwise.
    2. Growth - companies whose sales, earnings and market share grow at rates faster than typical companies or the economy. In addition to emerging growth companies, some blue chip companies also qualify as growth companies. Because these companies often plow back earnings into the company to fund growth and expansion, they usually do not pay large dividends. The growth of such companies and the paucity of dividend payments make them good wealth accumulators and tax-efficient ones at that since the growth in shares is only taxed upon realization in a taxable account. [The point is moot for tax deferred accounts in which the sale of a highly appreciated stock would not be a taxable event.] Long-term capital gains (where the stock is held for more than one year before being sold) are taxed at long-term capital gains rates rather than as ordinary income. Such companies may be appropriate for taxable accounts due to their low or non-existent dividend payout rates.
    3. Income - these tend to be cash rich companies that pay regular and steady dividends. Examples would be utilities, telephone companies and some blue chip stocks. Such stocks are often suitable for retirees and other investors with more of a need for income. Dividends are taxed as ordinary income. Such company shares may be better suited to tax-deferred accounts.
    4. Cyclical - the fortunes of these companies wax and wane in expanding and contracting economic conditions, respectively. Such companies tend to have large investments in property, plant and equipment (fixed costs). Industries in which one typically finds cyclical stocks include transport (automobiles, airlines and railroads), steel, machinery and paper.
    5. Value - these stocks tend to have low price-to-earnings ratios. Their price declines are often due to a temporary reversal in their business fortunes and await some sort of catalyst to unlock price appreciation. The fortunes of some do not always come to fruition, catching investment managers in whose portfolios they are located in a value trap.
    6. Defensive - these are companies whose shares exhibit all-weather attributes. Their prices are minimally affected by the whims of the business cycle. Powerful plodders, these companies evince steady, but slow growth, offering good downside portfolio protection, but with somewhat less upside in a rising market. Such companies provide products for daily living, the purchase of which would not be materially affected by changes in the economy. Examples include utilities, soft drink producers, grocers, pharmaceutical companies, tobacco companies and candy manufacturers.
    7. Interest-sensitive - companies whose business is commonly and materially affected by changes in interest rates. The housing industry is a good example, as lower interest rates make home purchases more affordable to most consumers. An increase in rates would cause the reverse to be true. Lumber companies, plumbing, furnishing and household equipment companies along with homebuilders are examples as well. Insurers, savings and loans, commercial banks and utilities are examples as well.
    8. Special situations - these stocks could fall into any of the foregoing categories. What sets them apart is that they are part of a corporate action such as a merger, acquisition, spin-off or buy-out. Often the corporate action will play a role in the share price in addition to the fundamental attributes for which the stock is known (e.g. a value stock that is an acquisition target may become more expensive by virtue of the fact that it is about to be acquired).
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