Stock Basics
What is a stock? First it is also known as an 'equity', either term is correct. Most often when we are talking about stocks, we are referring to what is called 'common stock'. There are other kinds to be discussed later. When a business meets certain criteria as to value, income etc., it may take legal action to become what is known as a 'public company'. It then divides its capitalization (value) into small units called shares. So, if you purchase a share of a company, you have become one of the owners of that business. Since you own part of that company, you are in a position to benefit from the prosperity of the company as well as assume all the risks that come with ownership.
How do we make money owning stock as an investor? We are potentially rewarded in two ways. The price per share of stock goes up and you can sell. (If the stock goes up and you don't sell, it is called an unrealized gain. This unrealized gain is not taxable and is not reportable anywhere until you actually sell.) The act of selling the stock causes it to become a realized and recognized gain or loss. This is when income taxes become an issue.
The second way to make money on our stock is through dividends. The board of directors for our company decides each year whether or not to declare a dividend. This is normally a payout of some of the company profits. This dividend may be characterized in different ways which will be explained by the company's Form 1099 issued to you at the end of the year. Dividends are not mandatory, the company may decide to keep profits (if any) to reinvest in the company or to pay down debt.
Characteristics of a Stock
A common stock can be identified and characterized in many different ways. We can consider it by size of the company it represents (big, small, or medium), by growth or value, foreign or domestic. We begin with a discussion of size.
Size
We start with capitalization which is basically the total value of a company's outstanding securities. How big a company is it? We need to know a company's capitalization as different sized companies tend to behave differently. Small cap (capitalization) is just what you would think; it is considered a small company. But what is small? Not everyone agrees. We care as investors because we are looking for asset allocation and if one mutual fund represents small cap as being less than five billion and another draws the line at one billion, we need to know of their different definitions as those two funds are likely to behave differently and we do not want to double up on a class of stock. What we like and use at Juniper Tree as a definition to achieve a proper allocation is as follows:
• Micro cap <250 million
• Small cap 250 million - 1 billion
• Mid cap one billion - 5 billion
• Large cap five billion – up (the term giant is also used for the largest of the large)
As we said, there are no set rules to classifying stock capitalization by size but, different sized companies do tend to behave differently, which makes this aspect of allocation an important part of designing our plan.
Small cap companies have out preformed large ones on a long term basis (since the great depression) and especially in the last few years. Noise is being made now that it is time for large caps to reemerge as the leader. In any event, small cap tends to have greater volatility than large caps. Volatility is the fluctuation of value of the security. In other words, the price of a small company stock is more likely to experience greater moves in price than a larger one. In our investment planning we want to have a portfolio with low volatility and a decent return. Having an exposure to volatile holdings like small caps and commodities can actually reduce total portfolio volatility because they frequently move in the opposite direction of traditional holdings.
Growth or Value
You may further categorize stock by identifying it as either growth or value. The price to earnings ratio (PE) is a popular way to measure growth vs. value. It is a tool created to help compare one company against another. PE is the price (P) of the stock divided by its earnings (E). (A $50 stock divided by its $5 earnings yields a PE of 10.) When you compare indexes like the S&P 500 (which represents 500 companies) with an early 2005 PE of 23 to its historic PE of 15-17, we see that it should be considered expensive. Where is the PE line drawn between growth and value, we would guess maybe 17 or less. This line is said to slide some with the interest rates. If interest rates are low, the theory is that the PE can be higher because a company has access to cheaper money which allows a PE to be higher and the company can still be profitable. We also hear about forward earning and PE. This PE is computed based on what analyst predicts for next year's earnings.
A growth stock is characterized by having an above average chance to increase its value by having its stock price rise. Typically it will pay little or no dividend and may or may not be operating at a profit. You may wish buy this stock as you see it doing well in the future. Say Amazon (AMZN) is trading for $35 a share and you feel it will be doing great in the future. Since at the time it was earning only about 73 cents for each share, (a PE of 48) you would be buying a growth stock. Therefore, you are betting that Amazon is going to have better than expected earnings and its stock price will soar. (Well at least go up.) One of my regrets is missing an Amazon stock purchase at around $6 a share. I had gone on line and ordered a book. It came in 2-3 days and it was cheap and easy to do. I read an investment report that said "this was an online bookstore and people were going to stop buying books because of the internet." I didn’t buy and the stock went to the range of $100 a share! You can't always trust the experts!
A value stock is pretty much the opposite. Altria or Phillip Morris (MO) is the quintessential value stock at printing was trading around 14 times earnings and paying a dividend yield of more than 4%.
So, which one is better to own, growth or value? The long haul has given the edge to the value approach, but graphs show the historic ups and downs. Short term trends tend to favor one or the other; from 1991 to 1993 value did well, from 1994 to 2000 growth was spectacular. In 2004 value was back in the lead.
