Investing in the Stock Market: Part One

Introduction

Depending on your investment profile, stocks can form a part of your investment portfolio. Before you start investing in stocks, you need to understand their nature and how they trade. Over the past half century, the general public’s interest in the stock market has grown substantially. What was once a toy of the rich has now become accessible to anyone seeking wealth. This newly developed demand coupled with advances in online trading technology allows anyone with investible cash to own stocks.

Notwithstanding their popularity, most people do not fully understand stocks. To make matters worse, people often engage in conversation with others who also do not fully understand stocks. There is a good chance you have heard people make comments such as: “John made a killing in the market, and now he’s got another hot tip ...” or “Watch out with stocks--you can lose your shirt in a matter of days!” Much of this misinformation is based on a get-rich-quick mentality. Some people even believe that investing in stock is the magic answer to instant wealth with no risk. The good new is that stocks can (and do) create massive amounts of wealth, but they are not without risks. The only solution to this is education. The key to limiting your risk and protecting your hard-earned capital is to do your homework before you put money in the stock market.

Different Types of Stocks

There are two main types of stocks: common stock and preferred stock.

Common Stock

When people refer to stocks they are usually referring to common stock. In fact, the majority of stock is issued in common stock form. Common shares represent an ownership interest in an entity and a claim, in the form of dividends, on a portion of that company’s profits. Although voting structures may vary, investors typically get one vote per share to elect the board members, who oversee management and their decions

Over the long term, common stocks, by means of capital appreciation, have produced higher returns than almost any other security or investment. However, this higher return comes at a cost since common stocks are subject to a number of risks. For example, if a company goes bankrupt and liquidates, the common stock shareholders’ claims are inferior to bondholders and preferred shareholders.

Preferred Stock

Preferred stock represents a lesser degree of an ownership interest in a company and usually does not offer the same voting rights as common stock, but this may vary among companies. One notable feature of preferred stock is that investors are usually guaranteed a fixed dividend. This is distinguished from common stock, which has variable dividends that are never guaranteed. An advantage of preferred stock is that in the event of liquidation, preferred stock shareholders are paid before common stock shareholders but only after debt holders’ claims have been satisfied. Preferred stock may also be callable, meaning that the company that issued the shars has the option to purchase or redeem the preferred shares from investors at anytime for any reason – for a premium in some events.

Many investors consider preferred stock to be more akin to debt than equity or common stock. One way to categorize preferred stock is to view them as a hybrid of bonds and common stock shares.

Different Classes of Stock

Common and preferred are the two main types of stock; however, it should be noted that companies oftentimes categorize stock into classes. The most common reason for classifying stock is the issuing company’s desire for the voting power to remain with a certain group. As a result, different classes of shares are given different voting rights. For example, one class of shares would be held by a select group of investors who are given five votes per share, while another class would be held by the majority of investors who are given one vote per share.

When there is more than one class of stock outstanding, the classes are traditionally designated as Class A and Class B. For example, Berkshire Hathaway (ticker: BRK) has two classes of stock. The different classes of stock are identified by the letter after the ticker symbol or after the period in the ticker symbol: “BRKa and BRKb” or “BRK.A and BRK.B”.

Understanding Various Ways Stocks Are Described

In addition to the classes a company might establish for its shares, industry experts often group stocks into sub-categories or subclasses. Common subclasses, explained in greater detail below, focus on the company’s market capitalization or size, sector, cyclical performance, and short and long-term growth prospects.

Subclasses have their own characteristics and are subject to certain external pressures that can affect their performance at any given time. Each individual stock’s behavior can be subject to a variety of factors as a result of its subclass(es).

Market Capitalization

If you follow investments news, you have probably heard the terms “large-cap, mid-cap, and small-cap.” These descriptors refer to company market capitalization, which is sometimes shortened to market cap. Market cap is a measure of a company’s size. Specifically, it is the dollar value of the company and is calculated by multiplying the total number of outstanding shares by the current market price.

There are no fixed value ranges for large-, mid-, or small-cap companies, but you may find small-cap companies valued at less than $1 billion, mid-cap companies valued between $1 billion and $5 billion, and large-cap companies valued over $5 billion; the numbers could very well be twice those amounts. In addition, micro-cap companies are less capitalized than small-cap companies.

Large-cap companies tend to be less vulnerable to volatility or the ups and downs of the economy than small-cap companies because large-cap companies typically have larger financial reserves and can afford to absorb losses and bounce back more quickly from a bad year. However, even the largest and most well-capitalized companies can fail. At the same time, small-cap companies may have greater potential for fast growth in an economic upswing than large-cap companies. Even so, there is no guarantee that any particular large-cap company will weather an economic downturn or that any particular small-cap company will thrive in times of prosperity.

Industry and Sector

Investment analysts subdivide companies by sector and industry. A sector is a large portion of the economy, such as industrial companies, utility companies, or financial companies. Industries, which are more numerous, are part of a more specific group. For example, banks are within the banking industry, which is within the financial sector.

Industries are frequently affected by economic events or business sentiment, which can affect an entire industry. For example, high gas prices stemming from geopolitical instability tend to lower transportation and delivery companies’ profits, and a new rule or regulation changing the review process for prescription drugs could affect pharmaceutical companies’ profitability.

Following a period of innovation and expansion, an industry can gain wide popularity amongst investors. Other times that once popular industry could be stagnant and have little investor appeal. Like the stock market as a whole, sectors and industries go through market cycles, providing favorable performance in some periods and disappointing performance in others.

An important part of creating and maintaining a stock portfolio is evaluating and re-evaluating what sectors and industries you should be invested in at any given time in the market cycle. After such a decision, you should then analyze individual companies within the sectors or industries you have identified as the best prospects for investment.

Defensive and Cyclical

Stocks can be further divided into defensive and cyclical companies. The difference between defensive and cyclical companies is the way their profit levels, and eventually their stock prices, respond to economic strength or weakness.

Defensive stocks comprise of industries that produce products and services that are everyday necessities. For example, more than most people, even in difficult times, will continue to use electricity and buy groceries. The continuing demand for these necessities or “staples” can keep certain industries profitable even during a weak or sluggish economic cycle.

In contrast, certain industries, such as travel and luxury goods, can be very sensitive to economic up-and-downs. These “cyclical” industries may suffer decreased profits and lose market value in times of economic hardship as consumers cut back on unnecessary expenses. However, cyclical industry stock prices can rebound sharply when the economy gains strength and people have more discretionary income to spend.

Growth and Value

One common investment strategy is to focus on either value or growth stocks. However, most investors seek a mixture of the two since their returns are often correlated with cycles of economic strength and weakness.

Growth stocks, as the name implies, are issued by companies that are in an expansion phase. Expansion phases can be short-term but can also last a longer period of time. In most cases, growth stocks are young companies in fairly new industries that are rapidly expanding. However, growth stocks aren’t always new companies. They can also be companies that have been in business for some period of time but are poised for expansion, which could be due to any number of things, such as advances in technology, foreign demand, and an overall change in business strategy.

Since growth companies tend to receive intense media and investor attention, their stock prices may trade at higher levels than their current profits seem to warrant. That is because investors are buying the stock based on potential future earnings and not on past earnings results. If the stock meets earnings expectations, even investors who have paid a high price may realize a profit.

Sometimes company management will take big risks to expand, so growth stocks can be very volatile or subject to large and rapid price swings. For example, a company’s new products may not attract consumers, there may be unforeseen difficulties doing business overseas, or the company may be highly leveraged in a period of rising interest rates. As always with investing, the greater the potential for an astronomical return, the higher the risk of loss.

When growth stocks provide positive returns, it is usually a result of stock price appreciation - the stock price moves up from where the investor originally purchased it. A key trait of most growth stocks is an absence of dividend payments to investors. Instead, company managers tend to plow profits back into the company to fund expansion or growth.

In contrast, value stocks trade at lower prices despite a positive earnings and balance sheet history. If you purchase a value stock, it is because you believe that it is worth more than its current market price. However, one of the risks associated with buying value stocks is that the low price as compared to earning is a legitimate reflection of its value. Older and more established industries tend to offer value because they do not get as much press as newer industries.

“Contrarian investors” invest against the prevailing opinion by buying stocks that are out of fashion and selling stocks that other investors are buying. This investment strategy can be profitable because a contrarian investor buys stocks at low prices and sells them at high ones. Contrarian investing requires considerable experience and a strong risk tolerance because it may involve buying stocks of companies that are distressed and selling stocks of companies that are performing well. Being a contrarian also requires patience because the company’s turnaround period may last longer than expected.

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