Chapter 3: Types of Stocks & Investing – Part 1

The one thing you cannot miss at a big fat Indian wedding is the loud music and the lavish buffet. With so many options on the table, how do you choose what you? Are you in the mood for a South Indian Spicy Mix or the classic Mumbai Masala? Yes, knowing the available cuisines definitely helps narrow it down, doesn’t it?

So, how to pick the right stocks from the buffet of stocks to choose from? Simple! Break it down into categories.

Let’s understand the various types of stocks and how to choose them.

1. Blue chip stock

You’ve heard of these companies, for sure!

But do you know what these companies have in common?

Well, they -

  • Have been running their business for years
  • Are very famous with a well-established performance track record
  • Show consistency in performance
  • Are pioneers in their respective industries
  • Have excellent financials

In terms of investments, these company’s stocks

  • Are categorized under large cap companies
  • Offer stable returns since they are already at the top
  • Since they are leading in their sector, you may not see a sharp downfall
  • Are highly liquid because they always have investors who are willing to buy these stocks

These are some examples of companies known as Blue Chip Companies. But more importantly, a blue-chip company may not always be a blue chip company for life.

Did you know? 

The term "blue chip" comes from the game of poker, where blue chips are the highest value pieces; Oliver Gingold, an employee at Dow Jones, coined the phrase 'Blue Chip' in 1923.

Who doesn’t love the excellent combination of stable returns and low volatility?

But how does one assess both these combinations in one stock?

There are many ways to assess but one efficient way is to check the Beta of a company.

What’s a Beta?

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 than the index. It's usually 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 low volatile stock and preferred by conservative investors with a low-risk appetite. Beta is also viewed as market risk or systematic risk.

This brings us to the next type of stocks.

2. High beta stocks

High beta stocks are stocks with a beta of more than one. Due to high beta, these stocks display high volatility and are preferred by aggressive investors. They also have the potential to offer higher returns compared to the benchmark index.  Stocks of companies from financial services, infrastructure, metals, etc. sectors are generally regarded as high beta stocks.

So, what are the stocks with low beta value known as?

Well, that’s our next type of stocks.

3. Defensive stocks

In simple terms, stocks issued by companies that belong to a sector not impacted by economic cycles are known as defensive stocks. Companies that fall under this category are healthcare, utility and food and beverages amongst others.

Makes sense, doesn’t it?

Because no matter the shape of the economy, you will still need food, healthcare and electricity.

So, as mentioned previously, these stocks typically have a beta of less than one and are considered low volatile stocks. Despite a market downturn, these stocks are not likely to fall much compared to other stocks. Hence, they are typically preferred by investors who do not want to take high risk with their equity portfolio.

But then what kind of stocks actually get affected by the economic cycle?

4. Cyclical stocks

So, conversely, cyclical stocks belong to those companies whose performance is dependent on economic cycles.

When the economy is in a boom phase, the demand for products from 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 from these industries declines, leading to lower earnings and falling stock price. Companies that fall under this category would be Steel, Cement, Infrastructure, automobile manufacturers or real estate companies.

By now, you may have figured why.

Because when the economy is not doing well, you are less likely to buy a new car or purchase a new house due to budget cuts.

Is it true what they say - The best stocks are always priced high?

Well, that is not necessarily true. Let’s look at one of the most popular types of stock.

5. Value stocks

These are stocks that are traded below their intrinsic value.

What does intrinsic value mean?

It is the company's actual worth based on objective calculations and not on the price at which the stocks of the company are trading in the market.

Let’s take an example:

Say you find a company – Ahuja International with a current share price of Rs. 100. But the intrinsic value of the company based on your calculations is Rs. 110 per share. In time, the stock market will realize the actual worth of the company and the stock will rise accordingly.

Value stocks are undervalued and have the potential to earn you good returns in the long-term.

But you might want to watch out because both value stocks and poor stocks are available at a cheap valuation.

So how do you differentiate between the two?

Just remember, value stocks are quality stocks beaten down by the market temporarily and have the potential to resurge and grow in the future. Some possible reasons for a temporary downfall could be earnings below expectations for a quarter, brief piece of bad news riding on high sentiment but with a lower financial impact, or just because of poor market sentiments. In contrast, poor stocks are those stocks which have low liquidity, an inconsistent earnings history, or poor metrics on standard financial ratios.

Also Read: Types Of Stock Trading In The Market

Did you know? 

The famous investor of all time, Warren Buffett has used the strategy of value investing for decades. He is also a very loyal follower of the Benjamin Graham School of Value Investing.

Now let’s touch upon the next type of stock - growth stocks in the next chapter

Summary

  • Beta is a measure of stock volatility with respect to stock indices like Nifty whose beta is considered one.
  • High beta stocks are stocks with a beta of more than one; these stocks display high volatility and are preferred by aggressive investors.
  • Stocks issued by companies that belong to a sector not impacted by economic cycles are known as defensive stocks.
  • Cyclical stocks belong to those companies whose performance is dependent on economic cycles.
  • Value stocks are undervalued and have the potential to earn you good returns in the long-term.

And the list doesn’t end here. There’s more to come in the next chapter.

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