rhallbick (99.79)

Categorizing Stocks

July 29, 2010 – Comments (5)

Investors often divide equities into categories in order to have a better understanding of what is their asset allocation and risk exposure.  The broadest categories are domestic vs. international companies, which has a good bit of overlap in the large capitalization (cap) arena.  Domestic stocks might then be divided into large cap, mid cap or small cap.  Or, they might be divided into their business sectors: technology, utilities, healthcare, industrial goods, financials, basic materials, consumer goods, services and basic materials.

Another way to categorize stocks is by the characteristics of the business.  This idea I originally learned from the writings of Peter Lynch.  He proposed that instead of trying to fit generic metrics to all stocks, you must first categorize a stock in order to make a valuation judgment on it.  Consider the following business types (these are essentially the ones he proposed) and where the companies you own fit in.

SLOW GROWERS

These are older large-cap companies that are expected to grow slightly faster than the gross national product (GNP).  There is normally not much volatility in their stock price and they pay out large, regular dividends.  An example would be an electrical utility.  Their historic stock price ranges from 7 to 9 times their annual earnings and if they are paying shareholders 50% of those earnings, that would result in a 3.5% - 4.5% annual return on the initial investment.  If things go well for the company, they might then pay out a little more in dividends each year, increasing the return for the investor.

RECESSION PROOF

These are large, stable companies that have steady growth in the 10-12% region.  These are considered low risk stocks to purchase during recessions, as they have strong financial strength and sell products that are purchased in both good times and bad.  Examples would be Pepsi, 3M, Hershey’s, P&G or General Mills.  Normally the telephone companies would fall into this category, but that industry is currently in a transition phase from landlines to wireless personal communication that is disruptive to their future earnings expectations.  The price per earnings (P/E) ratio for the recession proof companies normally ranges from 10-14.  Key issues to consider before purchasing one of these companies is the P/E ratio, whether the stock has gone up a lot recently and what is occurring at the company to accelerate growth.  There are a limited number of ways a company can increase their profits.  They can reduce costs, raise prices, expand into new markets, sell more products in old markets or dispose of a losing operation.  Note that it is often difficult to raise prices during a recession, perhaps prices have to be cut to retain market share.  Purchasing one of these companies at the depths of a recession might be expected to result in a 50% capital gain by the time the economy is humming along again, plus perhaps a 4-5% dividend yield while you wait.

GROWTH STOCKS

These are smaller new companies sporting a 20-25% annual growth rate.  They might be a restaurant or retailer who has perfected a business model in one location and then duplicates their success at new locations as they expand across the country.  The first thing to watch for is the performance of new locations.  Is the original model actually successful in the new locations?  Sometimes the growth of the number of outlets hides a relatively poorer financial result at the new locations.  If a new chain grows too fast, that also could also have a negative effect on your investment.  In order to finance the growth, the chain may take on too heavy a debt load or dilute your ownership with secondary stock offerings.  Too high a growth rate may also lead to inadequate supervision and quality control in the new locations.

The growth stock might be a company that is capitalizing on increased demand and/or higher prices for a product.  Funding becomes available from stock offerings and debt to purchase land, buildings and equipment.  Predicted future returns on investment are normally very high, since they are based on present day demand and price.  Eventually the demand growth stabilizes or perhaps even falls.  More likely than not, there is now an overcapacity for producing the product and the companies that have too high a debt load or too high a cost of production will fail.

The growth stock might be a producer of a new product or technology that is greeted favorably in the marketplace.  As a temporary monopoly, the profit margins can be very high and the growth outstanding.  Although many of today’s large cap companies began in this way, the eventual financial outcome is not assured.  Consumer tastes may change or the hot new technology may be made obsolete by new products from competitors.  During economic boom times, these high growth companies may be bought out by large corporations (that are flush with cash), which should result in a satisfactory financial return.

If a fast grower survives, over time, they usually turn into slow growers or recession proof companies, which changes the initial P/E ratio of perhaps 15-30% to 7-14%.  This change in how much investors will pay for a dollar of earnings has a dramatic effect on the stock price, thus investors must pay close attention to their company’s growth rate.  Wall Street can reclassify a company in an extremely short period of time.

CYCLICALS

Cyclicals are companies whose sales and earnings rise and fall with the economic cycle.  This group includes the car companies, airlines, chemical companies, construction materials and equipment, homebuilders and others.  The stock prices of these companies also rise and fall with the economy, always very dramatically.  Timing is everything in cyclicals and you have to be able to detect the early signs that business is falling off or picking up.  These stocks can lose 80% of their value in a down market and take years to recover.  In contrast with other stock categories, their P/E ratios are often highest when business is the worst and visa versa.

TURN-AROUNDS

Turn-arounds are companies that are dancing with bankruptcy.  Normally it is the result of poor management, although it could just be a very difficult business to be in.  There is no size restriction for one of these companies, it could be the corner grocery store or it could be a national chain.  If the problem is management, then new management and recapitalization could save the company.  If the problem is the business itself, then even the very best management cannot save it.  Some of the largest profits can be made with turn-arounds, if you have correctly predicted their recovery.

VALUE PLAYS

Value plays are companies that have assets that are not fully valued on their balance sheet, perhap because of accounting rules.  Perhaps that asset is a patent or a large tract of land or it might be a project working its way through research and development.  Perhaps that asset is a large amount of cash (which would be on the balance sheet) that can be intelligently deployed during a recession, when their competitors are strapped for funds.  This type of investment takes more than the usual amount of due diligence to acertain the true value of the company.  Even if your analysis is correct, it may take years for the value of the company to be reflected in the stock price.  Patience would be key here.