Understanding Stocks

As we discuss these equities and investment tools, let’s begin with the grandfather of them all, stocks. Stocks form the root of many indices, mutual funds, and ETF’s. As you understand the fundamentals of stocks and companies you can enter into trades with both individual companies and funds with greater confidence. It’s important to understand these differences as they influence risk and come with historically different rates of return.

8.1 Asset Sectors

Asset sectors often move in different cycles. When you know what drives each cycle, you can better understand how they fit within the trends. Learn when they are in demand and when they may fall out of favour. Discover typical risks and rewards.

Most investors use a sector breakdown of assets to balance their portfolio. These nine sectors offer a wide range of diversity within the stock market. This information will help you understand each sector and how it trends. Because we talk about the market cycle throughout this chapter, here is the chart to remind you of the cycle.

1. Consumer Discretionary: These are companies that produce goods and services considered nice to have, but not essential. People buy these products with ‘extra’ money. When the economy is good, people are more likely to spend money on ‘frivolous’ things, so consumer discretionary rises as the economy improves and flourishes in bull markets.

When the economy tightens, people cut back on the extras, so this class trends downward in a recession. Within this asset class, however, some stocks may trend differently. Cheap entertainment, like movies, tend to rise in bad times.

Some companies in this sector include:

• Bertelsmann (mass media)
• Amazon (consumer goods)
• Christian Dior (luxury goods)
• Walt Disney Co. (entertainment)
• McDonald’s (fast food)
• L’Oréal (cosmetics)
• NIKE (clothing)
• Time Warner (movies and entertainment)

1. Consumer Staples: These assets are considered essentials. People do not stop buying these products even in a recession. This sector includes agriculture, food, beverage, tobacco, and pharmaceutical distributors. It includes non-durable household goods and personal products, including grocery stores and supercenters.

Late in the cycle as economies enter a recession and during the recession, investors often move into consumer staples and prices rise. They believe assets keep their value better and are less likely to fluctuate in this sector. When times improve, money rotates out of this sector to faster moving assets and prices may dip. Overall, cycles tend to be more muted in consumer staples and they are often considered one of the safest and most risk free sectors.

Stocks in the consumer staples sector include companies such as:

• Anheuser-Busch (beverages)
• Walmart (retail)
• Procter & Gamble Co (retail)
• Sligro Food Group (grocery)
• Coca-Cola Co. (beverage)
• Philip Morris International (tobacco)
• Carrefour (retail)
• Unilever (personal care)
• Nestlé (consumer goods)

1. Energy: This category includes stocks related to producing or supplying energy. Traditionally, the energy sector has been dominated by oil and gas companies. Within the oil and gas industries, companies are broken down into three types, extraction (upstream), refining (midstream), and distribution (downstream) of gas and oil. Companies that engage in all aspects of energy production are called integrated companies. Integrated companies are less vulnerable to the change in the price of oil or gas because the cost of refining and transport may stay steady, when the cost of extraction rises or falls.

Upstream companies in exploration and extraction expand when energy is in demand and suffer when the price of energy drops. Because they are often heavily indebted, these companies often do not survive during down trends. They are more volatile and carry more risk. Downstream distribution companies may offer steady dividends in good times and bad.

Coal, nuclear power, and renewable energy such as water, wind, and solar are also included in the energy sector. Historically, renewable energy stocks were considered more speculative and carried more risk. As technology improves and renewable energy moves into the mainstream, the stocks are becoming more stable. These stocks can fluctuate based on government policies and rebates.

Which type of energy stocks are affected most when oil makes wild swings? When oil drops, drilling stocks like Apache Corp and Marathon Oil take a hit as do alternative energy stocks. When oil surges, they rise with the tide. But it also carries wind, solar, and electric vehicle stocks along with it.

Energy stocks include companies such as:

• Royal Dutch Shell (oil and gas)
• BP (oil and gas)
• Nordex AG (wind power)
• Yingli Green Energy Holding Co Ltd (solar)
• Canadian Solar Inc. (solar)
• ExxonMobil (oil and gas)

1. Financials: The financial sector covers financial services to both retail and commercial customers. This includes banks, insurance companies, thrift and savings plans, investment managers, mortgage companies, and real estate.

Financials tend to do well at the beginning of a recovery as credit begins to grow. They prosper in bull markets. In a recession, credit dries up and financials may see prices drop.

Real Estate Investment Trusts (REITs) follows a somewhat different cycle. They may be more dependent on interest rates. While insurance companies are often considered steady, dependable income in all market types. All financials are sensitive to changes in laws and regulations. Rising interest rates serve banks well, while falling interest rates reduce their bottom line.

Financial stocks include companies such as:

• ING (banking)
• BNP Paribas (banking)
• Allianz (insurance, annuities)
• HSBC (banking and wealth management)
• Munich Re (insurance)
• Morningstar (investment)
• Exor (investment)

1. Healthcare: Healthcare stocks deal with medical goods and services. This includes hospital management firms, medical equipment, and medical products. It also includes research, development, production, and marketing of medical equipment, pharmaceuticals, and new biotechnology.

All of these are considered essential so the healthcare sector typically performs well in all markets – bull or bear. However, it is subject to swings based on politics and government policies, subsidies, laws, etc. Pharmaceuticals and biotech stocks may rise or fall based on new product testing successes or failures or new competition to existing drugs. Early stage biotechs are considered highly speculative.

Companies in the healthcare sector include:

• Bayer (pharmaceuticals)
• Hoffmann-La Roche (pharmaceuticals)
• GlaxoSmithKline plc (pharmaceuticals)
• Fresenius (medical equipment)
• Capio Group (hospital management)
• Kaiser Permanente (HMO)

1. Industrials: Industrial goods are companies engaged in producing items used in manufacturing and construction. Sub-sectors encompass aerospace, industrial machinery, military and defence equipment. It includes cement, metal fabrication, pre-fab houses, and waste management. The Industrial sector also covers transportation companies such as airlines, trucking, roads and railroads.

Look to essential products like rail and defence to stay steady regardless of market trends. Huge, diversified industrials, such as General Electric, have offered good returns for years in all kinds of market swings. However, housing construction and industrial machinery generally slow in a recession.

Many analysts look to the trucking and transportation sub-sector as a bellwether, as those numbers tend to drop or rise ahead of a change in trend in the larger market. In this sector, it pays to look at specific trends within the broader sector as you choose your assets.

Companies in this sector include:

• International Airline Group (transportation)
• LafargeHolcim (building materials)
• Leonardo (aeronautics and defence)
• CRH (building materials)
• BAE Systems (aeronautics and defence)
• Schneider Electric SE (automation/equipment)
• Continental AG (automotive manufacturing)
• BMW (automotive)
• TUI Travel (transport)

1. Materials: Companies in this sector manufacture or process chemicals and plastics. They mine or extract minerals and metals. Paper, containers, and packaging are part of this sector. Some analysts include forestry and construction in this sector since they are closely aligned with packaging and are the raw material for many products.

Chemicals are used across a broad range of businesses so that they may hold up better under a range of cycles. However, in a downturn, the demand for them is reduced. Manufacturers use gold and other metals which affect asset prices. But precious metals also cycle with investor demand for a safe haven. Investors may turn to precious metals in times of economic and political uncertainty and tend to reduce their holdings as interest rates rise.

Companies in this sector include:

• BASF (chemicals)
• ArcelorMittal (steel)
• Rio Tinto Group (mining)
• LyondellBasell (chemicals)
• Dow Chemical Co. (chemicals)
• Rockwell Automation Inc. (automation)
• Silver Wheaton Corp. (metals)

1. Technology: This sector includes IT businesses and companies that research, develop, produce, and distribute communication equipment such as cell phones, towers, cable, etc. It includes computer hardware and software, home entertainment, office equipment, data management, processing systems, and consulting services.

Because technology is constantly evolving, new products can quickly become outdated. New inventions can drive up stock prices, sometimes dramatically. However, competition on price and better inventions put downward pressure on companies. These stocks usually have higher volatility and risk. They typically do well in a rising market and less well as markets shrink and customers cut back.

Many of these stocks have higher valuations because investors expect more and better products in the future. If their earnings statements fall short of expectations, the price typically takes a hit. Some traders use these volatility swings to trade options or CFDs.

Some companies in this sector include:

• Apple (communications)
• Microsoft (IT)
• Materialise (3-D printing)
• Skype (communication)
• Spotify (music streaming)
• Shazam (tag songs)
• Huddle (business software)
• Blossom IO Inc. (product management tools)
• Nginx (webserver)

1. Utilities: This sector distributes electricity, oil, gas, water, etc. Utilities that distribute energy have been considered ultra-safe stocks. Everyone needs energy in good times and bad. They have been used as income stocks to provide steady dividends for retirees. Utility stocks tend to rise in recessions as they are used as a safe haven. They may trend down in good times as investors shift to more profitable stocks.

Companies in the utility sector include:

• Engie SA (electric utility)
• ON ( electric utility)
• Kenon Holdings Ltd. (power generation)
• Artesian Resources Corporation (water)
• Azure Power Global Ltd. (solar power)

You can see that diversifying your portfolio over these sectors will give you stocks that rise in each phase of the market cycle. And some, like precious metals, that march to a different cycle altogether.

8.2 Finding Diversity in Stocks

Even within sectors, stocks are grouped based on size, production, dividends, and location. Each of these can bring investors added diversity. They also help investors assess risk and likelihood of growth or profit.

Size: Stocks can be grouped by the size of the company. Often this is called a market cap, short for market capitalization. Market cap is found by multiplying the number of outstanding stakes of stock by the stock price. Companies are divided into categories of small, medium, and large based on that number.

There are no rigid or official numbers for the groupings. Morningstar divides them by a percentage. For example, the top 5% of stocks in its database are labeled large cap. For investors wanting to evaluate this aspect of their companies, a dollar range may be more useful. Here are generally accepted definitions.

• Mega Cap: $200 billion or more
• Large Cap: Between $10 and 200 billion
• Mid Cap: Between $2 and $10 billion
• Small Cap: Between $300 million and $2 billion
• Micro Cap: Between $50 and $300 million
• Nano Cap: Below $50 million35

Traditional investors believe large cap stocks have the capital and depth to weather storms and consider them a safer risk. Smaller cap stocks offer more growth potential and have historically outperformed the large cap stocks. For example, the Wilshire Small Cap Value Index gained 371% between 1999 and 2013 while the S&P 500 gained only 97%. That’s a difference of 10.9% per year vs. 4.6% per year.36

But that increase came with volatility. Several of the years showed marked losses for the small caps. And if you go back to the 1984-1998 time frame, the S&P outperformed the small caps by 4% per year on average. Large and small caps cycle with one performing better in certain timeframes.

Some investors keep large caps for their stability and steady returns and add in some small caps for growth.

Growth: Companies are also divided into growth or income categories. Nearly every small cap has the goal to grow into a large cap. Small caps often take their profits and use them to grow their company. They may acquire smaller companies, plough back earnings into more resources to increase output, or seek to expand their range of products they offer. In these cases, investors don’t see payments in the form of dividends. Rather, they look for returns in the form of higher stock prices.

Income stocks, on the other hand, use less of their profits for growth, and return more of it to shareholders. Some companies return almost all of their profits to shareholders. Investors don’t expect these income stocks to increase in price as rapidly as the growth stocks… or even increase much at all. The security comes from having physical cash-in-hand in the form of dividends that will be there regardless of stock market swings.

Reinvesting these dividends back into stock stokes is one way to compound your interest and grow value. While past performance is no guarantee of future results, historically, reinvesting dividends has produced steady gains in a portfolio.

Not every small cap is a growth company and not every large cap is an income company. A check of historical prices and the history of dividend payments will help you recognise the kind of company you are dealing with.

Dividends: Stocks are divided into dividend and non-dividend paying companies. As mentioned before, those who do not pay dividends may be reinvesting profits to grow. Many investors prefer dividend paying companies because the dividends are in-the-hand, not paper profits. They can also be an indicator of the health of the company.

Rising dividends speak to the growth and health of a company. Many investors look for this track record of constantly increasing dividends. During a downturn in the economy, some cyclical companies may be forced to cut their dividends. If a company makes poor decisions, they may have to cut dividends. When companies cut dividends, their share prices tend to drop.

Here is six reasons dividends matter.

1. Dividends reveal fundamentals. When a company can pay steady dividends, it says something about the stability and fundamental value of the company. It’s possible for companies to be creative with the books, so dividends demonstrate cash profits. Companies MUST have the cash to pay out dividends. However, a high dividend in a company with low free cash flow can also signal a problem. It may mean it’s taking money from past, not current earnings, to pay a dividend. This is not sustainable.
2. Dividends force companies to manage better. A drop in dividends is seen as a failure of management and usually brings lower stock prices. Managers of dividend paying companies have an additional incentive to be wise. Studies show dividend paying companies pay less for acquisitions than those who do not pay dividends. So they are more efficient for stockholders. The managers begin the year deciding how much dividend they will pay out. Then they look for the most efficient way to use the rest of the free cash flow.
3. Dividends reduce market risk. When you have cash in your account from dividends, it stays there, whether the market goes up or down. Over a period of time, your stock may pay you in dividends what it cost you initially to buy the stock. For example, a stock with a 10% dividend will pay for itself in 10 years.
4. Holds up better in bear markets. Dividend paying stocks outperform in sluggish and in bear markets. They don’t go down as much in value and they tend to be less volatile. In a slow market, a larger percentage of the total returns come from dividends.
5. Outperforms non-dividend paying stocks. In the long run and on average, dividend paying stocks produce better gains than other kinds of stocks. The longer you hold dividend paying stocks, the better your returns tend to be. Typically over 27% of annual returns from the S&P500 come from dividends. This is from all the stocks in the index, both dividend paying and not. If you expand that out to 10 years, dividends account for 48% of the total returns of the S&P 500.
6. Dividends provide tax advantages. Depending on where you live, dividends may be taxed differently than other kinds of income. Check to see if this produces an advantage for you.

Investors who prefer the buy-and-hold or set-and-forget approach to their money may find dividend paying stocks to offer many advantages.

Location: Investors tend to buy stocks from their home turf. This makes sense. It’s easier to buy stock held on your country’s exchange and you are more familiar with domestic companies. However, there are advantages to diversifying beyond your borders.

International stocks help you take advantage of countries whose economies are in a different trend. They may be rising when yours are stagnant. It gives you the chance to pick up emerging companies with good potential. And sometimes the exchange rate makes foreign stock particularly inexpensive and attractive.

It can be difficult to buy the foreign stock if it is not available on your exchange. Sometimes it can be purchased over the counter (OTC) or off-exchange. Buying CFDs on the underlying stock also gives you a great deal of freedom to trade many international stocks.

Voting Rights: Traditionally, buying stock has given the stockholder voting rights in the company. This gives them the right elect board members, vote on executive compensation, and bring resolutions or demands to the company for all shareholders to vote on. If enough shareholders vote for a shareholder led proposals, they must be enacted. It takes either a consensus of many shareholders or the power of a few large shareholders to make changes contrary to the board’s approval.

Recently some new initial public offerings (IPO) stocks have been offered without voting rights. Companies going public for the first time, like Snap, have management who wants to retain full control of the company. Just be aware that shareholders of these kinds of companies have no ability to affect change within the company should they disagree with management.

8.3 Ways of Owning or Controlling Assets

The simplest way to control stocks is by buying them outright. This can be done with a single stock or a group of stocks. In Chapter 2 we discussed the advantages of owning stocks, mutual funds, index funds and ETFs. And how each may be used to help control risks and diversify your portfolio. We also covered controlling stocks without actually owning them through options and CFDs. Here are two other ways of holding assets.

REITs or Real Estate Investment Trusts are a way to hold income producing real estate as if it were a stock. Typically, they own rental units, hospitals, or businesses. Or they hold the mortgages on these properties. This kind of equity is required by law in some countries to pay out a large percentage of their income to the shareholder; therefore, it provides a regular stream of income and long term capital appreciation. It has tax consequences that are different from other stocks. Here, shareholders are responsible for taxes on the pass-through income.

Limited Partnerships can be traded on an exchange like a stock. This gives you more liquidity than would otherwise be possible were you to invest into a company as a business partner. While most partnerships are in resources – oil and gas, timber, or pipelines – some are also in real estate or finance. They have quarterly required distributions. They act like dividends, but they are mandatory and can come from sources other than cash flow.

The partnership pays no taxes, so their distributions are often higher than the average stock. However, the limited partnership share owners are responsible for all the taxes, and these taxes can be complicated.

Investors can own and manage assets in many ways. Because rights, fees, risks, and rewards all vary with different kinds of ownership or control, it pays to understand these different ways. Then you can choose the right one for your goals, your risk tolerance, and your investment style.