The Alphabet Soup Of Stocks

If you've ever watched financial TV or read financial papers, you may have heard of classifications like cyclical, growth and income stocks. As if the difference between preferred and common stocks wasn't enough, now more categories are adding to the confusion! In this article, we'll try to replace the confusion with some clarity and logic.

Stocks and the Business Cycle

Many stocks can be broken into categories that denote how they perform during various times of the year or business cycle periods:

• Seasonal - These companies are characterized by the different demand levels they face throughout the year. A snow shovel manufacturer, for example, is probably not very busy in the summer. Another seasonal effect is the increase in retail sales during the holidays. But investing in seasonal stocks doesn't mean you can automatically gain a healthy profit simply by purchasing a retail stock in the fall and selling it just after Christmas. Not all seasonal stocks are guaranteed to do well, even during their peak seasons. When you analyze financial statements for a seasonal stock, you need to compare results to the same season of the previous year.
• Non-Seasonal - These stocks are not affected by the change of seasons. Certain companies produce or sell goods that have what we call an inelastic demand curve. A good example is a peanut butter manufacturer - the demand for peanut butter is generally not affected by the weather or holidays.
• Cyclical - These companies, whose business activities intensely follow the economy's business cycles, are always the first stocks to reflect a recession or an expansion. These companies don't necessarily intend to follow the business cycle; it just so happens that their products share this relationship with the economy. A good example of a company with cyclical stock would be a car manufacturer or an airline company. Luxury is one of the factors in the relationship between these stocks and the business cycle. Take Porsche, for example: When the economy is doing well, sales of these fine automobiles rise. Conversely, when the economy goes into a slump, sales slow down.
• Non-Cyclical - This is the opposite of a cyclical stock. Profits of a non-cyclical stock do not change readily with the business cycle. These are companies that provide us with essentials, such as health care and food. Also referred to as defensive stocks, these stocks don't rely on the economic environment for increased sales. A perfect example is the diaper industry: Regardless of whether the economy is busting or booming, parents have to buy diaper for their babies.

Stocks and Dividends

Adding to the confusion, stocks are also classified according to their type of dividendpayout schemes. Note that this is separate from what we have already discussed. Dividend payouts have little to do with the seasonal demands a company faces; instead, they are determined by each company's individual policies and objectives.

• Growth - Growth stocks are known for their lack of dividends and rapidly increasing market prices. Defined by their tendency to grow faster than the market, these companies generally reinvest all earnings into infrastructure to maintain rapid growth, rather than directly paying out their earnings to investors. Young technology companies are often considered to be high growth, but the main characteristic of growth companies is that they believe that plowing earnings back into the research and development of new products benefits shareholders more than a dividend check every three months.
• Income - These stocks aren't (usually) growth hungry, or they've already reached their maximum growth potential. Income stocks' prices do not tend to fluctuate a great deal. However, they do pay higher-than-average dividends. An income stock's value depends on its reliability and track record in paying dividends. Generally, the longer a company has maintained dividend payments, the greater its value to investors. Historical examples of income stocks are real estate investment trusts(REITs) and utility stocks, many of which pay out annual dividends of 5% or more.

Stock Slang Terms

Finally, the financial industry uses many slang terms to describe and categorize stocks. These terms aren't always intuitive, but they do have their place in the financial world. Here are some of the many terms used to characterize stocks:

• Blue Chip - These companies are cream-of-the-crop, old-school and everlasting. Blue chips tend to be market mammoths and have proven their ability to survive through both good times and bad. The term comes from poker, where blue chips are the ones with the highest value. These companies are generally expensive to purchase but can be safe bets. General Electric (NYSE:GE) and Walmart (NYSE:WMT) are examples of blue chips.
• Penny Stock - The term "penny stock" denotes stocks that trade for less than a dollar, but it can also refer to stocks considered very speculative. These stocks are generally new to the market, with no reputation or history to fall back on. Penny stocks present the possibility of large gains or losses.
• Bo Derek - This is a term created by traders in the late '70s to describe the perfect stock. Back then, actress Bo Derek was considered "the perfect 10."
• Tracking Stock - Also known as "designer stock," tracking stock is a type of common stock, issued by a parent company, that tracks the performance of a particular division with no claim on the assets of the division or the parent company. Tracking stock also refers to a type of security specifically created to mirror the performance of a larger index.

 The Bottom Line

How do these terms fit with one another, you might ask? Well, next time you hear a cyclical income stock referred to as a real "Bo Derek," you'll know what it means. A stock's categorization can be varied and prone to change in different situations. Stocks that were once speculative may become blue chip, cyclical stocks can become non-cyclical due to some widespread economic changes, and seasonal stocks may reduce their exposure to seasonal pressures by exporting goods. Changing times mean that dynamic companies will change their visions and goals. The important thing is to not only remember what category a stock falls under, but also how it compares to other stocks of the same group.

Why Do Companies Care About Their Stock Prices?

Here's the irony of the situation: Companies live and die by their stock price, yet for the most part they don't actively participate in trading their shares within the market. Companies receive money from the securities market only when they first sell a security to the public in the primary market, which is commonly referred to as an initial public offering(IPO).

In the subsequent trading of these shares on the secondary market (what most refer to as "the stock market"), it is the regular investors buying and selling the stock who benefit from any appreciation in stock price. Fluctuating prices are translated into gains or losses for these investors as they shift stock ownership. Individual traders receive the full capital gain or loss after transaction costs and taxes.

The original company that issues the stock does not participate in any profits or losses resulting from these transactions, because this company has no vested monetary interest. This is what confuses many people. Why then does a company, or more specifically its management, care about a stock's performance in the secondary market when this company has already received its money in the IPO? Read on to find out.

Those in Management are Often Shareholders Too

The first and most obvious reason why those in management care about the stock market is that they typically have a monetary interest in the company. It's not unusual for a public company's founder to own a significant number of outstanding shares, and it's also not unusual for the company's management to have salary incentives or stock options tied to the company's stock prices. For these two reasons, managers act as stockholders and thus pay attention to their stock price.

Wrath of the Shareholders

Too often, investors forget that stock means ownership. Management's job is to produce gains for the shareholders. Although a manager has little or no control of share price in the short run, poor stock performance could, over the long run, be attributed to company mismanagement. If the stock price consistently underperforms shareholders' expectations, the shareholders will be unhappy with management and look for changes. In extreme cases, shareholders can band together and try to oust current management in a proxy fight. To what extent shareholders can control management is debatable. Nevertheless, executives must always factor in shareholders' desires since these shareholders are part owners of the company.

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Financing

Another main role of the stock market is to act as a barometer for financial health. Analysts are constantly scrutinizing companies, and this information affects the companies' traded securities. Because of this, creditors tend to look favorably upon companies whose shares are performing strongly. This preferential treatment is in part due to the tie between a company's earnings and its share price. Over the long term, strong earnings are a good indication that the company will be able to meet debt requirements. As a result, the company will receive cheaper financing through a lower interest rate, which in turn increases the amount of value returned from a capital project.

Alternatively, favorable market performance is useful for a company seeking additional equity financing. If there is demand, a company can always sell more shares to the public to raise money. Essentially this is like printing money, and it isn't bad for the company as long as it doesn't dilute its existing share base too much, in which case issuing more shares can have horrible consequences for existing shareholders.

The Hunters and the Hunted

Unlike private companies, publicly traded companies stand vulnerable to takeover by another company if they allow their share price to decline substantially. This exposure is a result of the nature of ownership in the company. Private companies are usually managed by the owners themselves, and the shares are closely held. If private owners don't want to sell, the company cannot be taken over. Publicly traded companies, on the other hand, have shares distributed over a large base of owners who can easily sell at any time. To accumulate shares for the purpose of takeover, potential bidders are better able to make offers to shareholders when they are trading at lower prices. For this reason, companies would want their stock price to remain relatively stable, so that they remain strong and deter interested corporations from taking them over.

On the other side of the takeover equation, a company with a hot stock has a great advantage when looking to buy other companies. Instead of having to buy with cash, a company will simply issue more shares to fund the takeover. In strong markets this is extremely common - so much that a strong stock price is a matter of survival in competitive industries.

Ego

Finally, a company may aim to increase share simply to increase its prestige and exposure to the public. Managers are human too, and like anybody they are always thinking ahead to their next job. The larger a company's market capitalization, the more analyst coverage the company will receive. Essentially, analyst coverage is a form of free publicity and allows both senior managers and the company itself to introduce themselves to a wider audience.

The Bottom Line

For these reasons, a company's stock price is a matter of concern. If performance of its stock is ignored, the life of the company and its management may be threatened with adverse consequences, such as the unhappiness of individual investors and future difficulties in raising capital.