Chapter 8: Types of Stocks & Investing
Chapter 8: Types of Stocks & Investing
There are various ways of choosing stocks for your portfolio. We will be discussing popular methods of stock selection or investing here:
8.1 Blue chip stocks
Blue chip companies have a well-established performance track record. These companies are typically pioneers in their industry and have large market capitalizations. They are preferred choices of investors who do not want to take a lot of risk with their equity investments. These stocks usually have stable earnings and normal growth rate. Investors can expect decent returns i.e. equivalent to market returns by investing in these stocks. These companies have a stable financial position and often pay dividends to shareholders. Stock like TCS, SBI, HDFC, ICICI bank, etc. can be considered as blue chip stocks.
8.2 High beta stocks
Beta is a measure of stock volatility with respect to stock indices like Nifty whose beta is considered one. If a stock’s beta is more than one, it is considered more volatile in comparison to the index and preferred by aggressive investors who have a high risk appetite. On the other hand, a stock with a beta of less than one is considered as low volatile stock and preferred by conservative investors who have a low risk appetite.
Beta is also considered as market risk or systematic risk.
High beta stocks are stocks that have a beta of more than one. Due to high beta, these stocks show high volatility and are preferred by aggressive investors. Stocks of companies from financial services, infrastructure, metals, etc. sectors can be considered as high beta stocks.
8.3 Defensive stocks
Stocks issued by companies that belong to a sector that is not impacted by economic cycles are known as defensive stocks. The demand for products of these companies is usually constant in the market irrespective of economic cycles, which lead to stable earnings and stable stock prices. The stocks of FMCG, utility, and healthcare companies can be considered as defensive stocks.
Defensive stocks typically have a beta of less than one and are considered as low volatile stocks. When a market takes a downturn, these stocks will not fall much in comparison to the market and are preferred by investors who do not want to take high risks with their equity portfolio.
8.4 Cyclical stocks
Cyclical stocks belong to those companies whose performance is dependent on economic cycles. When the economy is in the boom phase, the demand for products of these companies is high which leads to higher earnings and rising stock prices. On the other hand, when the economy is in a recession, the demand for products of these companies declines which leads to lower earnings and falling stock price. The stocks of cement, infrastructure and capital goods companies can be considered as cyclical stocks.
The valuation of cyclical stocks is difficult due to high fluctuation in earnings of the company as per economic cycles. It is not a good idea to evaluate a company on either growing phase earnings or down phase earnings. If we evaluate cyclical stocks in the boom phase, they may look under-valued, and similarly, they may look over-valued in the recession period. It would be better to evaluate these stocks based on one complete cycle i.e. based on average earnings.
8.5 Value stocks
Value stocks mean stocks that are traded below to their intrinsic value. Value stocks are available at an attractive valuation and can give good returns in the long-term. It is important to differentiate between a value stock and poor stocks as both categories of stocks are available at a cheap valuation. Value stocks are quality stocks that have been beaten down by the market temporarily and have the potential to come back and grow in the future. The possible reason for a downfall could be earnings below expectations for a quarter, some bad news which has high sentiment but lower financial impact, or just because of poor market sentiments. Value investing is a popular way of investing in the market and preferred by legendary investors like Warren Buffet.
8.6 Growth stocks
Growth stocks are stocks whose earnings are growing at a faster pace in comparison to peer group companies. Due to higher growth rate, these stocks command a higher valuation in comparison to their peers. These stocks have high P/E ratio and simultaneously have high growth rate that make the PEG ratio reasonable.
As these companies are in the higher growth trajectory, they require more funds for expansion. Due to this, these stocks will pay zero or very less dividend and plough back earnings primarily in the company only. The objective of growth investors is to look for a higher appreciation in share prices instead of getting dividend income. Growth stocks also carry a high amount of risk because high growth rate cannot be continued for a very long period and due to this, the stock cannot command a higher premium when growth rate falls to normal.
8.7 Momentum stocks
Momentum is known as the speed at which stock prices change. Typically, momentum shows the strength of the trend and stocks that show strong momentum in their price are known as momentum stocks. The momentum could be a down-trend or up-trend depending on the movement of the stock price. If prices are rising, it is known as an up-trend. Similarly, if prices are falling, it is known as a down-trend.
Usually, investors invests in up-trend momentum stocks at higher prices with the expectation that they will be able to sell at even higher prices. The investors who ride on the momentum rally early, are likely to benefit the most. For new investors, momentum can be a trap if they ride on the stock late, when the rally is going to collapse. The reason why momentum strategy works is that no one wants to be left out. When a stock starts trending up, investors and portfolio managers fear that they are going to miss the next big move and so they start jumping in. This pushes the stock even higher and so on.
Momentum investing relies on technical data rather than fundamentals. Momentum investing can work but it is may not be practical for all investors. Momentum investing is not necessarily for everyone but it can often lead to impressive returns, if done properly.
8.8 Growth at a reasonable price (GARP)
GARP is known as Growth at reasonable price. It is a combination of growth and value investing. It was popularized by legendary investor and portfolio manager, Peter Lynch. In GARP investing, investors try to identify growth stocks that are available at a reasonable valuation. The aim is to identify growth stocks which consistently show above average earnings growth but do not have a higher valuation. These stocks have average P/E ratio and higher earnings growth rate and because of this, their PEG ratio s is equal to one or lesser than one. .
There is a difference in GARP and value investing. Value investors look for stocks that are available at a bargain and the risk of losing money is less compared to GARP.
8.9 Income stocks
Most investors invest in the equity market for capital appreciation but there are few stocks which can also earn good dividend yields. These stocks are a preferred choice of conservative investors who are looking for regular income in the form of dividend. The motive of these investors is to earn a regular income along with chances of capital appreciation. These stocks also carry a low risk in comparison to the market. In the Indian market, a few high dividend yield stocks can provide yields in the range of 6-8% p.a.
8.10 Index investing
Index investing is all about having the same combination of shares in the same ratio as the target index so that it replicates the index itself. A change in holdings happens only when a company enters or leaves the index. This strategy will not beat market returns but makes sure that you do get at least the returns offered by the market. It is essentially a passive form of investing.
Index investing is good for those investors who do not want to take the risk of creating their own portfolio but want to invest in a fully diversified index. Index investing is not equivalent to earning the best returns but getting returns equivalent to the market.
Index investing works in a different manner and the best way to invest in this is through mutual funds or ETFs. There are many index mutual funds and ETFs in the market and one can subscribe to either of them to follow this strategy.
8.11 Contrarian investing
As the name suggests, contrarian strategy is all about having a contrary view against majority investors. This strategy assume that because of the interest of majority investors, securities may be mispriced. Contrarian investors take an opposite view and invest against the wind. This strategy can offer high returns if the market moves in favour of contrarian investors. Otherwise, it could be very risky as you have try to sail against the wind.
This strategy may seem similar to value investing but the major difference is that this approach relies more on market sentiments and investor behavior. The biggest challenge with this strategy is to find the turning point when stock prices start correcting themselves.