With overwhelming choices available to you in order to build your portfolio, it is important to know what you are getting into as an investor. Owning a stock makes you a part owner of a company. There are two primary categories of stocks: common and preferred. Each of these have different attributes and offer different benefits and rights.
Common Stocks
When we think generally about stocks, this usually refers to common stocks. Common stocks are usually issued and bought in large numbers. When you buy common stocks, you are considered as a shareholder of the issuing company. In other word, you are a part owner of that company. There are both benefits and restrictions. Firstly, as a shareholder, you are given the right to vote for the board of directors (or executives) who will be managing the company.
Secondly, you also have a share in the profits or loss of the company. However, this is not always a guarantee because stockholders may lose their investment as owners if the company loses money from its operations, or goes into bankruptcy. In the event of liquidation where the company goes bankrupt, the preferred stockholders and lenders of the company (like bondholders and other debt holders) will be given priority over the assets. The common stockholders only get what’s left over. Lastly, common stockholders are given preemptive rights. For example, let’s say you own 100 out of a company’s 2000 shares. If one day the company issued another 1000 shares, and you were not allowed to buy the newly issued stock, that would mean your 100 shares are now considered as a lower percentage of the company than before. As a common stockholder, you have the preemptive right to buy newly issued stock so that you can keep the same proportional percentage of the ownership.
Preferred stocks
Preferred stockholders like common stockholders, also own a part of the company. However, these stocks are different in a number of ways. Typically, these stocks do not come with voting rights. Like debt and security, preferred stocks can be considered a fixed income investment as the company will pay fixed dividends, regardless the performance of the company. On the other hand, common stocks have variable dividends. Therefore, preferred stocks provide a potential stable income but will not be able to offer the same growth potential as common stocks. For such reasons, preferred stocks are usually seen as debt more than equity.
Preferred stocks are issued in limited numbers. This is how a company limits the control of shareholders while still offering equity investment opportunities to raise funds for the company. Therefore, preferred stocks are not widely available to public. Some companies are restricted to take on more debts due to the risk of being downgraded. Preferred stocks offer an alternative option for the company to raise capital.
In addition, preferred stocks have the advantage over common stock in certain areas. For example, in the event of liquidation, the debt holders will receive compensation first, followed by preferred shareholders and lastly, the common stockholders. Preferred stockholders have a greater claim to a company’s assets compared to common stockholders. Many investors are attracted to the preferred stocks because they offer a steady income stream as dividends without lengthy maturity dates like bonds and treasury bills. In addition, they are not subject to market fluctuations like common stocks.
As a general comparison, we can conclude that bonds have the lowest risks, preferred stocks have higher risks, and lastlys common stocks have the highest risk. Having said that, common stocks have the highest yielding returns than the other two. In the comparison of these three, preferred stocks have the highest popularity because they do not have long maturity dates like bonds, nor do they have fluctuations of dividends like common stocks. However, since the dividend payments to preferred stocks are fixed, the stocks will not increase in value as the company profits grow, unless preferred stockholders are willing to turn them into common stocks.
Market Capitalization
Another term commonly used in describing the stock is market capitalization. Market capitalization or “market cap” is the market valuation of a public firm to measure a company size. It can be calculated by multiplying the number of outstanding shares which are held by the shareholders with the current market price per share. For example, if a company’s current market price is $600 per share and they have 900 million shares outstanding, then the market capitalization of this company is $540 Billion. A company with more than $10 Billion market cap is commonly called a large cap; a company with $1 – $5 Billion a mid cap, and and lastly a company with less than $1 Billion a low cap.
Market capitalization is commonly used to estimate the risk and returns. The share price can not represent the capital size of a company. Let’s say stock A trades at $5 per share, while stock B is trades at $10 per share. Do we conclude that Company A’s stocks is cheaper than Company B? The answer is no, because Company A could have 50 million outstanding shares with a market cap at $50 Million, while Company B could only have 500,000 outstanding shares with market cap at $5 Million.
However, the market capitalization does not truly reflect the value of a company. For instance, if there were a few limited edition Mercedes that were worth $200,000 dollars each, and person A pays $250 000 for it while person B pays $150 000, these prices do not reflect the true value of the car – they were just prices paid for them. Likewise, many other factors come into determining a share’s true value. In conclusion, we should understand that the market cap is what we pay, but what truly counts is how much it is actually worth.
Sectors and Industries
Spotting the market trends and identifying the developing sectors are crucial in making wise investment decisions. A “sector” is a collective term used to describe a group of businesses who serve products or services and operate with similar characteristics in a particular area of the economy. For example, some sectors are financial, hospitality, technology, resource, energy and more. They share similar business characteristics and usually perform the same market trends as well.
We can further break down sectors into different divisions, defining these as “industries”. For example, banking is an industry in the financial sector. The whole sector often moves together responding to the economic conditions. Wealth is often transferred from one sector to another. As such, to catch wealth, you need to be able to follow the market and successfully invest into growing sectors.
Another key consideration is choosing from secular stocks and cyclical stocks. Secular sectors often referred to companies that produce basic needs in our daily life. For instance, healthcare, consumer staples, food and beverages. Consequently, the demands do not fluctuate as much due to the economic conditions. On the contrary, buying cyclical stocks includes buying from sectors such as luxury goods, retail goods and travel services providers. The demand is often supported by a strong economy. Its consumer demand is based on choice, but not necessity. Thus, cyclical sectors are heavily affected by the general economic conditions, as opposed to secular sectors.
