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Unlocking Stock Categorization: 6 Different Criteria Explained

Introduction

Investing in stocks is a great way to grow and diversify your portfolio. But there are so many different stocks out there, it can be tough to know where to start. To make sense of it all, it helps to classify stocks into different categories based on their fundamental characteristics. In this article, we’ll take a look at what exactly stocks are, how they’re categorized, and the factors to consider before investing in each type of stock.

What are Stocks?

Stocks represent a partial ownership of a company. When you purchase stocks, you become a shareholder in the company and have the right to receive a proportional share of the company’s profits. Depending on the company, these profits can be distributed in the form of dividends, or reinvested back into the company. The price of stocks is determined by the demand and supply of the securities in the market. When the demand for a stock increases, its price tends to go up, and when the demand decreases, its price tends to go down.

Classification of Different Types of Stocks

1. Categorization Criteria: Market Capitalization

Market capitalization is a way to classify stocks based on their size. Large-cap stocks are generally more valuable than mid-cap or small-cap stocks, and therefore command a higher price.

Large-cap: The top 100 companies in terms of market capitalization. These are the market stalwarts and famous brand names. They also tend to pay good dividends to their shareholders. Generally speaking, companies with large-caps are seen as more stable and less risky than mid- and small-cap stocks.

Mid-cap: Companies ranking from 101 to 250 in the list of companies based on market capitalization. These are growing companies that have been around for some time and have a sizable customer base. These stocks have higher growth potential, but they’re more sensitive to economic cycles and industry trends, which can make them less predictable.

Small-cap: All other companies. The majority of the stock market consists of small-cap companies. While some of them offer huge growth potential, others fail to survive the economic volatility. Generally, small-cap stocks are considered riskier than the other two categories.

2. Categorization Criteria: Ownership

Stocks are classified according to their ownership. Preferred stocks offer a higher dividend, while common and hybrid stocks do not.

Common stock: Offers ownership in the company with voting rights to elect the board of directors. Common stockholders are eligible to receive part of the company’s profits via dividends.

Preferred stock: Offers ownership in the company but doesn’t come with the same voting rights as common stocks. These stocks receive promised dividends that are not available with common stocks. Also, if the company liquidates, then these stocks get preference over common stocks.

Hybrid Stocks: Combines features from both preferred and common stocks. The most common type is the convertible bond, which allows investors to convert their bonds into equity or debt.

Convertible preference shares: Initially issued as preference stocks that can be converted into a fixed number of common stocks at a specific time. The company can decide whether to offer voting rights with these stocks or not.

Stocks with embedded derivative options: Once a company issues shares, it usually doesn’t buy them back unless it deems fit. However, some companies offer stocks with embedded derivative options, like call and put options.

In the call option, the company can buy back its stocks at a specific price or a specific time. In the put option, the investor can sell the stock back to the company at a specific price or a specific time.

3. Categorization Criteria: Fundamentals and Financials

Stocks can also be categorized based on their fundamentals and financial metrics. These classifications help investors assess a company's financial health and performance.

Value Stocks: These stocks are characterized by low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, and other fundamental indicators suggesting they may be undervalued. Value investors believe these stocks have the potential for price appreciation as the market corrects its valuation.

Growth Stocks: Growth stocks are companies with a history of strong revenue and earnings growth. They typically have high P/E ratios and may not pay dividends because they reinvest earnings into the business for further expansion. Investors in growth stocks expect future capital appreciation.

Dividend Stocks: These stocks belong to companies with a history of paying regular dividends to their shareholders. They are favored by income-seeking investors, such as retirees, for the steady income stream they provide.

Blue-Chip Stocks: Blue-chip stocks are shares in well-established, financially stable, and reputable companies. They are often considered safe investments and are known for their reliability and stability.

Cyclical Stocks: These stocks are closely tied to the economic cycle. Industries like automotive, construction, and travel are examples of cyclical sectors. Investments in these stocks tend to perform well during economic upturns and poorly during downturns.

Defensive Stocks: Defensive stocks belong to industries that are less affected by economic cycles. Examples include healthcare, utilities, and consumer staples. Investors turn to defensive stocks during economic downturns because they are more resilient.

Penny Stocks: These are low-priced stocks, typically trading for less than a dollar per share. Penny stocks are highly speculative and often associated with higher risks due to their low market capitalization.

Microcap, Small Cap, and Mid Cap: Beyond market capitalization, stocks can be further categorized into microcap, small cap, and mid cap based on their market value. Microcap stocks have the smallest market capitalization, followed by small caps and mid caps, in increasing order of size.

Understanding these categorization criteria can help investors make informed decisions and build a diversified portfolio tailored to their financial goals and risk tolerance.

Conclusion:

Investing in stocks is not a one-size-fits-all approach. The categorization of stocks based on market capitalization, ownership, fundamentals, and financials provides investors with a framework to navigate the complexities of the stock market. By considering these categorizations, investors can align their investments with their financial goals, risk tolerance, and investment horizon.

Whether one seeks the stability of blue-chip stocks, the growth potential of value or growth stocks, or the income from dividend stocks, the categorization criteria serve as a valuable tool for constructing a well-balanced and diversified stock portfolio. As with any investment, it's crucial to conduct thorough research and seek professional advice when making investment decisions in the stock market.