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Different kinds of stocks
Not sure what a small cap is or why you should care? Read on.
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In Lesson 5
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Money 101 Lessons
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There are thousands of stocks to choose from, so investors usually like to put stocks into different categories: size, style, and sector.
A company's size refers to its market capitalization, which is the current share price times the total number of shares outstanding. It's how much investors think the whole company is worth.
Ford, for example, has 2.11 billion shares outstanding, and in December 2007 each share was trading for $6.90. So the company's total market capitalization is about $14.5 billion. (Technically, if you had an extra $14.5 billion lying around, you could buy each share of stock, and own the whole company.)
Is $14 billion a lot or a little? No official rules govern these distinctions, but below are some useful guidelines for assessing size.
Large-cap companies tend to be established and stable, but because of their size, they have lower growth potential than small caps.
General Electric, one of the most highly valued companies in the world with a market cap of more than $380 billion, has posted steady long-term returns, but don't expect it to double anytime soon.
Over the long run, small-cap stocks have tended to rise at a faster pace. It's much easier to expand revenues and earnings quickly when you start at, say, $10 million than $10 billion. When profitability rises, stock prices follow.
There is a trade-off, though. With less developed management structures, small caps are more likely to run into troubles as they grow - expanding into new areas and beefing up staff are examples of potential pitfalls. (Of course, even corporate titans get into trouble. Witness the collapse of General Motors' stock in 2005, when the share price fell from about $40 to about $20.)
A "growth" company is one that is expanding at an above-average rate. Cisco, for instance, increased its earnings nearly 40 percent a year in the late 1990's - the average tends to run around 10 percent.
Catch a successful growth stock early on, and the ride can be spectacular. But again, the greater the potential, the bigger the risk. Growth stocks race higher when times are good, but as soon as growth slows those stocks tank.
If you'd picked up 100 shares of Cisco in 1995, your stake would have cost you a little more than $3,000. By early 2001, that investment grew to $68,400.
Cisco fell from grace, however. If you were unlucky enough to have purchased Cisco shares at their absolute peak price, you would have lost nearly 90 percent of your money by September 2002, when the stock was trading below $9.
The opposite of growth is "value." There is no one definition of a value stock, but in general, it trades at a lower than average earnings multiple than the overall market. Maybe the company has messed up, causing the stock to plummet - a value investor might think the underlying business is still sound and its true worth not reflected in the depressed stock price.
A "cyclical" company makes something that isn't in constant demand throughout the business cycle. For example, steel makers see sales rise when the economy heats up, spurring builders to put up new skyscrapers and consumers to buy new cars.
But when the economy slows, their sales lag too. U.S. Steel, the largest steel maker, lost money during the recession of 2001. Cyclical stocks bounce around a lot as investors try to guess when the next upturn and downturn will come.
Standard & Poor's breaks stocks into 10 sectors and dozens of industries. Generally speaking, different sectors are affected by different things. So at any given time, some are doing well while others are not.
In most cases, finance, health care, and technology tend to be the fastest growing sectors, while consumer staples and utilities offer stability with moderate growth. The other sectors tend to be cyclical, expanding quickly in good times and contracting during recessions.
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