Stock Classification Basics

There are many ways to categorize stocks (and the collective vehicles such as mutual funds that invest in them) such as by industry and sector, or by country or region.  This post will focus on two of the criteria that are perhaps a bit more esoteric and less self-explanatory, but just as important to understand.

The first criterion is market capitalization, or “market cap” for short.  This is simply the total value of all the outstanding stock of a given company, or, the company’s size.  There are three basic market cap categories:

  • Large Cap:  total value of company stock is over about $10 billion
  • Mid Cap:   total value of company stock is between about $2 billion and $10 billion
  • Small Cap:  total value of company stock is less than about $2 billion

These categories are further subdivided; “micro cap” stocks are those at the very smallest end of the small cap category, while “giant” or “mega” cap stocks are those at the very high end of the large cap category.

Generally, the smaller a company’s market cap, the greater both its risk and, correspondingly, its potential long term return.  This is true for the following reasons.  First, a smaller company is generally newer, not well known, and not well established, so the investment is more speculative.  The company is probably limited in both its business line and its market and is more vulnerable to “shocks” such as increases in interest rates or an economic downturn.  Also, shares in smaller companies tend to be less liquid and therefore harder to trade than those of larger companies.  Investors therefore demand higher returns from smaller companies to compensate for this added risk.

The second criterion is known as “style”.  Before defining the different “styles”, it is important to understand what it is one is buying when investing in a share of a company’s stock.  That is inherent in the word “share” – the investor has ownership of a share of the company’s sales, earnings, assets, etc.  How much that investor is paying for a dollar of a company’s sales, earnings, or assets is given by (among others) the following ratios:  price to sales, price to earnings, and price to book, or P/S, P/E, and P/B, respectively.  This is the price per share divided by the sales, earnings, or book value per share.  These ratios are also known as “multiples” or “valuations”.  When stocks are described as “cheap” or “expensive”, it is these ratios that are used.  All else being equal, higher values for these ratios mean a stock is more “expensive”, while lower values mean a stock is “cheap”.

“Value” stocks are those that are “cheaper” by these measures.  Value-style managers seek to invest in companies that are overlooked by the market or are being unfairly punished for some reason, thus resulting in the lower valuations.  The hope is that the market will then correct its “mistake”, resulting in an increase in the stock’s price.  The risk is that it is the market, and not the manager, which is correct about the stock and the anticipated increase in price does not occur.  Value-style investing can be seen as the embodiment of the investing maxim “buy low, sell high”.  Value style stocks also tend to have higher dividend payouts, so their returns are a combination of dividend income and share price appreciation.

In contrast, “growth” style investing can be said to follow the maxim “buy high, sell higher”.  Growth style stocks are those that are “expensive” according to their valuations/multiples.  However, to the growth-style manager, the potential for further strong growth makes the cost worth it.  Growth style stocks tend to be more volatile than value style stocks and run the risk that the manager investing in them bought a stock that indeed did have valuations that were unjustifiably high.  Growth stocks also tend to be hit the hardest in a correction or downturn.  Unlike value stocks, growth stocks usually pay little or no dividends as these companies prefer to reinvest, or “plow back” their earnings into the company to foster further growth.  The returns on growth stocks are therefore entirely in the form of share price appreciation.

The third style category, called “blend” or “core”, are those stocks whose valuations/multiples fall in between those of value and growth stocks and exhibit characteristics of both.

The familiar Morningstar style box provides a good at-a-glance look at both the market cap and style of a stock or a stock mutual fund.  It consists of nine smaller boxes, like a tic-tac-toe game.  The vertical axis is the market cap (small, mid, and large, moving from bottom to top), and the horizontal axis shows style (value, blend, and growth) moving from left to right.  So, for example, a large cap growth fund or stock would plot in the upper right square, while a small cap value stock or fund would plot in the lower left square.

Stocks of different market caps and different styles perform differently in different market and economic conditions and it is all but impossible to determine which type will lead in the short run.  Therefore the prudent approach is to have a well diversified portfolio that is balanced and holds each of the various types of stocks.

As always, if you have any further questions, please do not hesitate to contact our office (610-651-2777).