Most people know stocks are key to building a successful investing strategy, but few people understand the depth and variety of the stocks available to investors. With something like 10,000 publicly traded companies, a big part of investing involves sorting and filtering through those choices. Even broad index funds don’t cover all 10,000 available offerings.
But how do you go about categorizing companies, which can be as unique as people?
The easiest way to categorize stocks is to sort them by basic attributes—the size of the business, the type of company, or the industry they operate in. However, this can only tell investors so much.
A harder, more relevant approach may be to group stocks based on performance—either what they’ve done in the past or how we hope the stock will perform in the future. (Remember, past performance does not predict future results.)
Let’s review a few ways financial professionals categorize stocks and how the different groupings fit into our investing strategies at Revo Financial.
Value stocks
Value stocks are companies with strong fundamentals that may not be reflected in the firms’ share prices. Strong fundamentals can refer to everything from a solid leadership team to consistent revenue growth or a growing research division. In fact, how an investor analyzes a company’s fundamental business is, in many ways, considered the secret to success in this type of investing.
This approach, favored by famous investors like Warren Buffett, looks to identify strong companies and buy them on “sale,” then reap long-term returns as share prices increase to reflect the company’s inherent value.
Momentum Stocks
Momentum investing takes a cue from Newton’s first law: An object in motion tends to stay in motion. As the name implies, momentum stocks tend to be “on a roll” and trending upward. Momentum investors don’t try to buy stocks at the very bottom and sell at the very top. Instead, they look to buy shares that are already increasing in price, then sell them when technical indicators signal momentum may be running out.
Growth Stocks
Most investors buy stocks hoping their share price will increase over time (buy low, sell high). With growth stocks, however, this is a more prominent consideration. Analysts try to identify companies that will grow faster than average. Often, these are smaller companies that reinvest any profits back into the business to spur growth (versus paying them to shareholder). These companies may be newer and focused on innovation—think tech firms or pharma companies researching new drugs. As you might imagine, these companies often carry a significant amount of risk alongside the potential for high returns.
Income Stocks
While growth-focused companies prefer to reinvest profits, other companies prefer to share their profits with investors, usually via dividend payments. These payments can generate income for shareholders, which is why dividend-paying stocks are also called income stocks. (It’s worth noting, dividend payments are taxed differently than gains derived from selling shares of a stock.)
Income stocks tend to be larger, established companies with stable financials. Many income investors take this a step further and look for companies with a history of increasing their dividends over time.
Cyclical Stocks
The economy goes through cycles of growth and recession, and cyclical stocks tend to fluctuate along with the broader economy. For instance, during a recession, people may spend less money at restaurants, flights, hotels, or luxury goods, making those companies (and their stock prices) vulnerable when the economy is weak.
Defensive Stocks
Companies that do not fluctuate along with economic cycles, or that perform better during downturns, are referred to as defensive stocks. They play ‘defense’ for your portfolio when other companies may be losing value. Defensive stocks tend to be companies that produce goods or services that people use regardless of economic conditions—healthcare, groceries, utilities, and so on.
“Which stocks should I invest in?”
This may be the most common question we get—not just from clients, but from friends, family, and even strangers. While there’s no one-size-fits-all answer, some types of stocks are more appropriate for different situations.
Value stocks may be a solid choice in the long run, for example, but they can underperform in the short term since it’s hard to know when share prices will begin to reflect underlying value. Momentum stocks, on the other hand, may help you maximize potential growth in the short term, particularly during bull markets.
Understanding the distinctions among various types of stocks can help you process why we shift the holdings within your equity allocation depending on market conditions. The categories also provide a helpful framework for evaluating performance against objectives.
At Revo Financial, we use a long-term approach to investing, while also working to optimize performance in the short term. We leverage machine learning and data from Helios Quantitative Research to help spot momentum and growth-based investment opportunities while still maintaining a more traditional, value-driven approach.
