The ABC's of Stocks

Stocks can be put into various categories in order to make it easier to identify them. Although there are a number of classifications, some stocks, for example, are classified according to the rights that they confer on the shareholder, or the investment characteristics, or the market capitalization. Investors look at these categories based on their investment objectives and, as a result, seek out stocks that have the qualities that they’re looking for.

Let’s look at the two most fundamental categories of stock: common stock and preferred stock. What differentiate these stocks are the rights that they each bestow on the owner.

Common stock ownership entitles the shareholder to certain voting rights regarding company matters. Typically, common stock shareholders receive one vote per share to elect the company's board of directors. However, the number of votes is not always proportional to the number of shares owned. Common stock shareholders also receive voting rights regarding other company matters such as stock splits and company goals.

Additionally, common shareholders are sometimes given what are called preemptive rights. In the event the company issues another stock offering, these rights give the shareholder the right but not the obligation to purchase as many new shares of the stock as it would take to maintain his or her proportional ownership in the company.

Although common stock holders have different rights and privileges, there is one big drawback to owning common stock -- you’re the last in line to receive the company's assets. Consequently, common stock shareholders receive dividend payments only after all preferred shareholders have received their dividend payments. In addition, if the company goes belly-up, common stock shareholders receive whatever assets are left over only after all creditors, bondholders, and preferred shareholders have been paid in full.

Preferred stock holders do not enjoy any of the voting rights of common stockholders. These shareholders get paid a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. However, owning preferred stock give these shareholders a greater claim on the company's assets than common stockholders. In addition, they always receive their dividends first and, in the event the company goes bankrupt, they're paid before common stockholders.

If you’re looking for stocks based on their investment characteristics, here are the most common classifications:

Blue-chip stocks represent the biggest companies in the country. They are also some of the safest stocks to invest in. Blue chips are usually the stocks of high quality companies with years of strong profit and steady dividend payments. They are part of the Dow Jones Industrial Average, including Coca-Cola, and Wal-Mart, and IBM. Because of their large size, there is virtually no potential for a high growth rate, so most of the return of these stocks is in the form of dividends. You will probably not get rich overnight by investing in these stocks, but you will sleep better knowing that you won't lose your hard-earned money either.

Income stocks generate most of their returns in dividends, and the dividends -- unlike the dividends of preferred stock or the interest payments of bonds -- will, in many cases, grow continuously year after year as the companies' earnings grow. These companies have a high dividend payout ratio because there are few opportunities to invest the money in the business that would yield a higher return on stockholders' equity. Many of these companies are already very large and are considered to be blue-chip companies.

Cyclical stocks respond to economic issues on a seasonal or cyclical basis. For example, automobiles are classic cyclical stocks. When the economy is growing and people are working, car sales do well. However, if there are layoffs and uncertainty or high interest rates, people may decide to hold on to their car another year.

Cyclical companies can be found in a range of industries including paper, chemicals, steel, machinery and machine tools, airlines, railroads and railroad equipment.

Non-Cyclical Stocks do well in economic downturns, since demand for their products and services continue regardless of the economy. Classic examples of non-cyclical stocks are household non-durable goods, such as toothpaste, toilet paper, and cleaning materials. When the economy is growing, cyclical stocks tend to lag behind; however, during economic downturns, their steady returns may look attractive.

Growth stocks are shares of companies that are growing rapidly and have the potential of generating higher returns on your investment, but those higher returns come with higher risks. For instance, if a growth-oriented company doesn't grow as fast as anticipated, then its price will drop as investors become more pessimistic about its future prospects.

One of the advantages of owning growth stocks is that capital gains, especially long-term gains where the stock is held for at least one year, are generally taxed at a lower rate than dividends, which are usually taxed as ordinary income.

Tech stocks are shares of technology companies, most of which trade on the Nasdaq. These companies make computer equipment, communication devices, and other technological devices. Since research and development efforts are hard to evaluate, tech stocks are considerably riskier. Because technology is continually evolving, the fortunes of these companies can shift quickly, especially when current technology becomes obsolete as a result of new technology.

Sometimes stocks are categorized according to their market capitalization, or market cap. Market cap is calculated by multiplying the current share price with the number of shares outstanding or issued by the company.
Large-cap stocks, for instance, consist of the blue-chip companies that have a market cap greater than $5 billion. These securities have the best price stability and the least risk. Since these companies are so large, there is little potential for growth. However, capital gains can be earned by buying shares at the bottom of a business cycle and selling them as the economy reaches full speed.

Small-cap stocks are small companies that have the greatest potential for growth. Most of these stocks are growth or speculative stock. Small-cap companies are valued at less than $1 billion.

Mid-cap stocks are valued between $1 billion to $5 billion, so their market caps range from the top of the small-cap market to the bottom of the large-cap market.

A stocks category is not written in stone. Because of changes in the economy, securities can shift from one category to another. For example, a small-cap company can grow way beyond $1 billion market cap and become a mid-cap stock. However, the reverse could also occur.

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