The stock market universe is vast: By some estimates, there are approximately 630,000 publicly traded companies around the world, with 6,000 listed on U.S. exchanges alone. While there are numerous ways investors classify stocks to suit investment strategies, three of the most common designations are growth stocks, value stocks and cyclical stocks.
Professional investors often allocate investments based on these categories. Index and mutual funds track stocks that fit these parameters, and investment managers may tie risk tolerance to investments in growth or value. Let’s take a look at how to understand each category.
Growth Stocks
What they are: A growth stock refers to a company whose revenues and earnings are increasing — or expected to increase — at a faster rate than the average equity’s. As a result, their share price should theoretically appreciate (finance-speak for “rise”) more rapidly than the stock market overall.
While growth stocks exist in every industry, they’re most commonly found in newer, non-traditional fields, emerging sectors and businesses characterized by innovation and constant research and development: high-technology, alternative energy, medical/biotech. Not surprisingly, growth stocks often represent small and mid sized companies. They can be big, household-name corporations, too, if they have higher-than-average earnings and the potential to keep growing. Tech-sector giants like Amazon, Alphabet (Google’s parent), and Netflix are still considered growth stocks, because — successful as they’ve been — earnings growth has remained strong as they evolve and enter new markets.
Two other characteristics of growth stocks: They generally have higher price-to-earnings (P/E) ratios versus the benchmark indexes like the S&P 500 or the Dow-Jones Industrial Average. And they usually don’t pay dividends, because either they have no excess profits to distribute, or they prefer to plow profits back into the company.
What investors should know: Growth stocks are often considered higher-risk. It’s largely their potential that’s fueling many younger firms’ rise — and shares could tumble dramatically if corporate earnings don’t live up to their promise, if their sector hits a snag, or if innovations don’t deliver as expected. Also, their shares can be expensive and driven by speculative excitement. Investors in these equities should have a long-term time horizon to weather performance bumps and industry changes.
Value Stocks
What they are: If a growth stock is the belle of the equities ball, a value stock is the wallflower. It’s a fundamentally sound, solidly performing company that for some reason is being overlooked or undervalued by investors. Its share price and P/E ratio tend to be lower compared to the overall market or its sector averages — and to what its dividends, sales, or earnings may otherwise warrant.
Value-stock investors are basically bargain hunters: They see a chance to buy a valuable company at a discount, like art at an auction or high-end electronics on sale. Eventually, if the market realizes the company’s intrinsic value, the stock may rise again, offering a superior return to those who snapped it up at lower prices, the strategy goes. Benjamin Graham is one of the best-known proponents of value investing.
Value stocks can be in any industry, but they tend to be larger, well-established companies, unlike the upstart growth stocks. And, in contrast to growth investors who are following the buzz and betting on the next big thing, value investors are somewhat contrarian, ignoring trends and waiting for a company to be rediscovered.
What investors should know: Value stocks are considered safer on the risk spectrum, though not without risk: The shares may never recover from whatever is depressing them, or they might take years to do so. So, value investors need patience to realize gains. However, they often get an immediate return in the shape of income, as value stocks often pay strong dividends.
Cyclical Stocks
What they are: Cyclical stocks are those that follow the ebb and flow of the economy. They perform well during periods of prosperity and may fare poorly during recessions and financial crises. All equities do to some extent, of course, but these stocks are particularly sensitive to business cycles.
That’s because cyclical stocks represent companies that are heavily dependent on industrial activity, consumer demand and discretionary spending. You’ll find them in sectors like travel (airlines, hotels), dining and hospitality (restaurants), retail (luxury/big-ticket items, like furniture and appliances), industrials (automaking and mining), and banking. When times are good, firms are investing to ramp production to serve a growing economy, which benefits their earnings. When times are tough, earnings for these companies can come under pressure as manufacturers and consumers restrain spending.
The opposite of cyclical stocks are defensive stocks — companies in the business of providing goods and services that are consumer essentials, like groceries and utilities.
What investors should know is cyclical stocks can be highly volatile: the first to soar when a bull market gets going, and the first to fall when the bears start to growl. Investors interested in them follow economic and business forecasts, and they often market-time purchases and sell-offs, and they may dollar cost average to smooth returns over cycles
Originally published on Tornado.com: Growth, Value and Cyclical Stocks — Deconstructing the Market
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.