A stock or a share gives you a small ownership in a company — as the word “share” itself implies, you are sharing something with the company. As the company earns profits or losses, your stock price either appreciates or depreciates. For example, if a Company has 100 shares and you own 10 shares, you own 10% of the company.
Stocks play a very important role in a diversified portfolio. They are dependent on the growth rate of the economy and automatically adjust for the rate of inflation (the rate at which expenses increase) and other positive macroeconomic signals. As a consequence, they offer a higher rate of return compared with traditional or debt instruments.
Consider the case of McDonald's burger, which were priced at $2 a year ago, assuming 5% inflation now it costs $2.1. McDonald's can pass on any increase in its cost to consumers by increasing prices, hence increasing its revenues and earnings — this results in a higher share price.
Further, any increase in the disposable income of people will positively impact profits for McDonald's. This makes a stock a perfect instrument to counter inflation and earn higher returns during economic upturns.
Historically, stocks had delivered a return of 12% over a very long period whereas debt instruments or gold had given a relatively lower return. Unlike stocks, debt instruments continue to yield the same returns with no adjustment for inflation, disposable income, or euphoria shared by the economy.
Stocks not only provide higher returns but also lead to lower volatility (risk of downside or excess movement) in your portfolio. Generally, the concentration of stocks in a portfolio depends on the time horizon and age of a person (which directly affects the risk profile of an individual).
A young individual shoulders less responsibility and has ample time to hold a portfolio thus making way for a higher risk appetite. In contrast, usually an older individual has a lower risk appetite because of all the responsibilities that comes with having a family. Thus, she holds a smaller proportion of her income in stocks and balances the portfolio with other asset backed instruments. Stocks are not an effective tool for diversification in the short term since they are long term instruments and may lead to excessive risk due to their cyclical nature. Young investor should invest at least 30-40% of its portfolio in stocks or equity related mutual funds.
An investor is entitled to two streams of income when he holds a stock:
- Capital Gains – Appreciation in stock prices (Unrealized Gain unless you sell at a higher price).
- Dividends - Cash you receive from the company or share of profits (Realized Gains)
When a company earns profits. Part of those profits is retained by the company for expansion plans or is further invested in the operations of the company. This increases the value of the company which is reflected in an increase in its stock prices (Capital gains). Capital gains are considered unrealized and only get realized when the stock is sold. For example, if you purchased the stock at $100 and currently it trades at $150, you have an unrealized gain of $50.
Dividends are paid by the company in cash. So if a company earns $100 and has a dividend payout ratio of 20% (percentage of profits paid as dividends to shareholders), then it will pay $20 as dividends (Realized Gain) to its shareholders and retain $80 which will be reinvested in the company (80% is also known as Retention Ratio).
Generally, companies with more investment opportunities or the one's in their growth stages do not distribute dividends whereas companies in mature stages of business distribute most of their profits as dividends. Take the case of, Pfizer which in it's current mature stage distributes 100% of its profits as dividends. Whereas Facebook which is in it's growth stages of business does not pay any dividends, since profits are required to be injected back in the business for more opportunities.
Stocks are categorized into various sectors based on the business they do or operations they conduct. Below are the examples of various sectors:
- Consumer Discretionary — Companies which are dependent on consumer income levels. The higher the income, higher are the sales. Example - General Motors, MGM and Beazer Homes.
- Consumer Staples — Companies which sell necessities like FMCG (Fast moving consumer goods) or other daily use items. Example: Colgate-Palmolive, Procter & Gamble and Unilever.
- Energy — Companies catering to energy needs. Example: Exxon Mobil, Chevron and British Petroleum.
- Health Care — Companies operating in healthcare or pharma industry. Example: Pfizer, Abbott Laboratories and Glaxo Smith Kline.
- Informational Technology — Companies providing information technology services. Example: Microsoft, Intel and Facebook.
- Telecommunications — Companies providing telecommunication services including wireless services. Example: AT&T, Verizon Communications and Orange.
- Financials — Companies providing financial services and other finance related services. Example: Citibank, Wells Fargo and AIG
The above sectors do not represent the list of all the sectors. Further, sectors can be classified into subsectors. For example, financials can be classified into banks, insurance, broking and fund management companies.
Stock portfolios should never be concentrated on a particular sector. Different sectors go through vastly different phases of the business cycle which makes it very important to diversify between sectors. For example, a portfolio of stocks heavily inclined towards financials sector in 2008, after the financial crisis would have suffered the most. Similarly, a portfolio heavily invested in energy sector in recent crude oil fall would have performed poorly. Your portfolio should be well balanced between defensive and aggressive sectors.
Sectors like healthcare or consumer staples are considered defensive due to stable nature of their business. Whereas companies dependent upon price of commodities like steel or crude are cyclical in nature and are largely dependent on price of commodities. Your stock portfolio should be a mix of sectors which not only reduces the overall risk and volatility but also safeguards you from any sector specific event.
Market cap is the overall value of the company as of today (Market Cap = Total Shares x Market Price). Companies are classified into three categories based on the market cap:
- Small Cap — Small companies in budding stages of their business with high growth prospects
- Mid Cap — Relatively smaller companies with growth prospects
- Large Cap — Matured companies with stable businesses
Companies with market cap of less than $2 billion are classified as small cap. These companies are in their initial stages of growth and have huge growth potential. They are the most risky stocks due to the high risk involved in their business. They either may prove to be multi baggers (their stock price multiplying multiple times) in the long run or may prove to be wealth destroyers. They perform better than midcaps and large caps during positive economic conditions but can take a massive hit during down cycles. Some portion of a diversified portfolio should be allocated in these stocks for better performance and to ensure huge profits in the long run. Companies like Spectrum Pharmaceuticals, NEC Corp and Group 1 Automotive fall under this category.
Small caps are further classified into Micro caps. Companies with less than $500 million of market cap comes under this category. Micro caps are very small companies which are excessively risky in nature. They may prove to be extraordinary wealth creators in the long run. Very few micro caps will end up becoming mid caps or large caps.
Companies with market cap between $2 Billion and $10 billion. These companies are in the growth stages of their business and have a relatively higher growth potential than large caps or matured companies. They have a potential to become large cap companies in the future but the risk is that they can become small cap stocks too. Due to relatively smaller scale of business, they are more prone to major economic events. Companies like Under Armor, Psychiatric Solutions and Aeropostale fall under this category.
Midcaps perform better than large caps during optimistic economic events but perform worse than large caps during turbulent times.
Companies above the market cap of $10 billion are classified as large cap. These companies are stable in nature and have a significant size advantage. They have stable track records and long operating histories. Companies like McDonald`s, AIG, and MGM fall under this category.
Giant Stocks are a subset of large cap stocks and include companies which are very big in size. These companies enjoy sectoral monopoly and operate on a very large scale. Top 10% of companies by market cap or companies with market cap of $200 billion can be classified under this category. Likes of Apple, Microsoft and Facebook are some examples of Giant companies. Over a long run, they may not provide extra ordinary returns but may prove to be safe investments.
Stocks are also categorized by their investment style:
- Growth — High Valuations, High Growth
- Value — Low Valuations, Undervalued Stocks
- Income — Mature companies, High Dividend Yield
Growth companies are high growth companies and grow at a higher rate than the industry and also trade at higher valuations compared to their peers. Growth stocks are classified by high PE ratio (Price to Earnings ratio covered in later sections) and high PEG Ratio (Price Earnings to Growth ratio covered in later sections). Generally small caps or mid caps which have high growth potential are classified as high growth stocks. They command high PE ratios and perform well during growth phases. The risk attached with these is immense as they may fail to grow at the same pace during long runs leading to no or negative returns.
These companies trade at less than their value (being undervalued in nature). They trade at a lower PE and PB (Price to book) ratios and are fundamentally sound companies. For example, ABC company known for its quality products trades at a PE of 10 with a very high ROE of 25% (Return on Equity explained in later sections) whereas XYZ company with moderate quality products trades at a PE of 25 with a ROE of 5%, which makes ABC a value stock. Sometimes high growth companies also fall under this category since market has still not recognized their high growth potential.
Value Stocks are regarded as High Quality Stocks and may be difficult to discover from an investor viewpoint but once they start performing it is difficult to ignore such stocks. These companies trade at less than their fair value — they are also known as "bargain buys". Sometimes value stocks may take a long time to reach their fair price. This tests investors patience, thus, the best strategy is to hold such stocks if fundamentals are evidently strong.
These are mature companies with stable operations and low growth prospects. They do not retain profits with them and instead distribute all their profits as dividends to their shareholders. Also known for their high dividend payout ratios and high Dividend yield (Dividend / Share Price discussed in later sections). They are low risk companies and are suitable for investors who are looking for a regular source of income. Companies like Pfizer, Exxon Mobil, CocaCola, Procter & Gamble are high dividend paying companies.