Companies are not all alike. For example, what Starbucks sells is very different from what Exxon sells – and we’re not referring to the fact that we don’t drink gasoline! People need gasoline to drive to work and get around – even if the price reaches $4.00 per gallon – but people don’t need to spend $4.00 for a cup of coffee if they can’t afford it. Heck, some people don’t need to drink coffee at all, while others cannot function without at least that first morning cup of coffee, and there are those who need a pick me up cup of coffee all through the day. When it comes to investing your hard earned money, you should keep this in mind. Generally, buying stocks in companies that sell things we need reduces risk. The following types of companies are worth exploring for consideration:
1. Defensive Companies
Defensive companies sell things we need. Food companies, such as Kellogg’s and Campbell’s are examples. We also need fuel, prescription drugs, and consumer “staples” like toothpaste, soap and laundry detergent. We even need the services of funeral homes to bury our dead!
The name “defensive” comes from the fact that if the economy is showing signs of faltering, you can defend your wealth by buying the shares of these companies. While companies that sell premium coffee and other luxuries will likely see declines in sales and profits that will lead to falling stock prices, defensive companies will continue to chug along. We’ll keep eating and a certain portion of the population will continue to pass away. Have you known a person who skipped showers and tooth brushing because the economy wasn’t doing well? Didn’t think so!
2. Income Companies
Imagine that a company provides natural gas for heating and cooking to homes on a populated island through a network of pipes laid under the island’s streets. The company is in an interesting situation. On the down side, it doesn’t have opportunities to grow. On the up side, it doesn’t have much competition. For a would-be competitor to tear up all the streets on the island to lay gas pipes next to the company’s existing ones would be nuts!
So, what’s the company to do with the profits it consistently earns? The decision most of these companies make is to pay out a significant percentage of their profits to their shareholders who, after all, are the owners of the company!
These payouts to shareholders are known as dividends. Holders of these companies’ stocks go to their mailboxes four times (the number of times dividends are paid) each year and retrieve checks that represent significant income!
3. Growth Companies
Ever been in a situation where something – maybe the last piece of amazing chocolate triple-layer cake at a crowded party- was there for the taking? You knew that if you didn’t grab it, and soon, someone else would.
Some companies find themselves operating in markets that have so much potential for new products, they know if they don’t get these new products out soon, a competitor will. A great example of a market with tremendous potential is the cell phone market.
Growth companies have made it their priority to grow their sales and profits rapidly. When those profits are made, they’re “plowed back” into new product development. As a result, growth companies pay little or no dividends, making them a less attractive investment for retired people who need their investments to pay them regular income. However, if they can gain leadership in growing markets, their stock prices can rise significantly. This attracts younger investors to who want to build wealth.
Finally, how can we tell if a company is growing rapidly? Generally, if its profits and sales are growing 15% per year or more, we can definitely consider it a growth company.
4. Blue Chip Companies
Back in the day, the most valuable poker chip was blue. Investors began giving the name “blue chip” to large, well-known, stable companies that had what it takes to remain leaders in their industries year-in and year-out for decades!
Blue chips may not stand out in any one regard. They may not be growing as fast as growth companies or paying dividends as high as income companies. Their stock prices may not be rising as fast as the latest darling of investors. All they do is continue to grow steadily and dominate their markets!
5. Cyclical Companies
The economy alternates between periods, or cycles, of growth and contraction (aka recession). When the economy moves from contraction to expansion, businesses and governments that had been holding off on construction projects give the go-ahead and buildings, bridges and roads are built. Basic materials such as cement and steel will be in great demand. Companies that provide them do well at these times and not so well when the economy slows down. As a result, they are known as cyclical companies.
Perceptive investors can “rotate” out of these companies when the economy is slowing down and transition their investment dollars into defensive companies.
Taking this a step further, imagine if there were companies we could invest in that would do better than normal when the economy is headed into a recession. Such companies exist. For example, as consumers begin watching their spending closely, they visit “dollar stores” more frequently. People who are really down on their luck may have to pawn some of their belongings, so pawn shops may experience increased business in downturns.
Another type of business that benefits from bad times is the collection agency, a company that specializes in getting people who are behind on their bills to pay up! Perhaps we should name companies that do better as we’re heading into a recession “anti-cyclicals!
6. Value Companies
Dexter and his friends are walking down the street. A group ahead sees something lying in the street. It’s a genuine Frisbee brand flying disc. Dexter watches as they take a quick look and walk past.
When Dexter comes to it, he sees it has some dirt on it but otherwise looks to be in good shape. Yet, he walks past as well. Why did Dexter walk by the Frisbee?
This is the story of value stocks – companies that are being ignored by investors. Dexter probably walked by the Frisbee because he saw his buddies walk by it as well. No one wanted to be the person to pick it up.
Similarly, companies sometimes wind up being thrown in the street. For example, the United States’ auto industry has experienced a tremendous amount of trouble. General Motors went bankrupt. Ford, to its credit, didn’t need government assistance, but its share price dropped after sales plunged. As these big names cratered, what do you think happened to other companies that offer auto-related products? They fell as well. Did they all deserve it? No. Let’s say that one company has advanced technology that enables it to project a vehicle’s information onto the windshield. This means the driver no longer has to take his or her eyes off the road to see important information such as the vehicle’s speed and fuel level. Let’s also say that this company’s technology can be transferred to other industries.
Does this company deserve to have its stock beaten up? No. Its sales and profits are strong. But, the black cloud of auto industry trouble looms large and investors are too scared to buy its stock.
Eventually, an insightful group of investors takes a look at the company with new eyes. They realize that if they put aside perceptions and bias, what they see is a company with great technology and solid sales and profits, with a stock price that’s downright cheap! In short, the stock is on sale, and like any good sale, it represents a great value!
7. Penny Stocks
If there’s a Wild West in the investing world, it would have to be penny stocks. These stocks get their name because their prices per share are usually in the pennies (i.e.: less than a dollar) and are often less than one cent! A penny stock may have a price of $.0033, representing a third of a cent.
What makes a company a penny stock is the owners’ decision to “go public” by selling new shares to the broad investment community before the company has established a track record of substantial and rising sales and profits. Investors who buy its shares at this point are taking a big chance because they’re buying into an idea that may or may not pan out. For example, a company may claim that it is developing a part that when installed in a car doubles the gas mileage. It needs $1 million to finish the product and market it to the automakers. If it works, you could get rich. If it doesn’t, well, your entire investment will probably be lost. These companies need every penny (no pun intended) people invest in them, so they do not pay dividends!
There are other concerns with penny stocks. The stock price can swing wildly, doubling or losing half its value in a single day. It is often difficult to research them. If you bring up the symbol of a penny stock on a popular financial web site, many of the usual links will be dim because they are not available.
In addition, the shares of these tiny companies don’t change hands between buyers and sellers all day long as with larger companies. If you want to buy shares, you may have to pay a stubborn seller a high price to get his or her shares. If you want to sell, you may find little interest among buyers and have to drop the price you are willing to accept to motivate a buyer to step up and take them. The ability to sell quickly without having to drop the price significantly is called liquidity, and penny stocks lack it! Penny stocks are extremely risky and should be avoided!
While the ability to distinguish between the different types of companies is important, there are other important guidelines to keep in mind when investing.
For one, you should think about your own risk personality or “profile”. You may be young and yet naturally cautious, relying on the “slow and steady wins the race” philosophy in life. If you are risk-averse, then you may never own growth stocks because they can rocket higher and fall just as rapidly.
Still, most young investors try to grow their wealth rapidly by putting more of their money into growth stocks. The thinking is that if these volatile stocks fall, young investors have plenty of years for them to recover. The older an investor gets, the more attractive blue chips and income stocks begin to look. Older investors have fewer years to make up a drop in the value of their investments and these types of companies are less likely to fall significantly! This discussion shows why it is important to examine the stage of life you are in.
Studies show it’s nearly impossible to be successful “timing the market” (i.e.: jumping in an out of stocks to lock in profits and wait to buy later at a lower price). Still, it’s worth examining the state of the US and global economies before you begin investing. If economies and industries are growing you stand a better chance of having your initial investments earn money than if economies are falling into recession. Investing is a life-long process, yet there’s no reason to begin on a down trend.
Think as well about how active you are likely to be managing your investments. If you don’t have the aptitude or energy, be honest with yourself about it. You can invest in mutual funds, allowing professional fund managers to choose investments for you. Or, you may purchase index funds which allow you to invest in the market as a whole. If you want to become an expert at investing and are ready to make the commitment to do so, your increasing expertise may lead you to add cyclical and value stocks to your investing radar.
Another important investing basic is to diversify your investments among not only different stocks but different types of investments (called asset “classes”). For example, real estate, bond, and commodity investments will move up and down based on different factors than your stocks will! Mutual funds can help you achieve this diversification.