Few stocks perform like Microsoft, which has doubled, on average, every 14 months. Nor are all investors beating the bushes to find the next Microsoft. Why not? Because for every stock that delivers turbocharged returns, there are hundreds or thousands that simply dry up and blow away. So rather than risk plowing all their money into the next high-tech train wreck, most people fill their portfolios with a variety of different types of stocks that have different profiles of performance. Here are five of the major types:
* Growth stocks. Microsoft is a classic growth stock -- but any stock with rapidly rising profits fits the bill. Typically growth stocks trade at price/earnings ratios that are equal to if not greater than their expected growth rates (for more, see "Identifying bargains"). While growth investing can be highly profitable, it can also be risky because the same investors who love a stock when its earnings are expanding smartly may bail out in a hurry if the growth rate slows. That, in turn, can drive the stock’s price through the floor.
* Momentum stocks. Think extreme
growth investing. Momentum investors buy stocks in companies with
earnings that are growing at increasingly higher rates. Indeed, some momentum
investors will buy a stock simply because its price is going up. This can
be a very lucrative investing strategy, but it only works for limited
periods of time (as short as hours to minutes, for some day traders). The risk is that it's tough to pick when that time will end. And when the music stops, as it invariably does, anyone left holding an unloved momentum stock could see its value disintegrate.
* Value stocks. Another way of saying
"cheap stocks." These are simply issues that are undervalued compared to
their real earnings potential. The market is down on them because their
earnings have taken a temporary hit, their product line is in a momentary
lull, or some other passing event has knocked their price down. The key
word here is "passing." A value investor bets that whatever ails these companies will end, and that -- given enough time -- their price will rise to reflect their true value. Oddly, value stocks are sometimes growth stocks that are past their prime. For example, IBM, one of the great growth stocks of the 1970s and '80s, fell from grace in the early '90s after several years of disappointing earnings. But some value investors determined that the company’s earning power was much greater than Mr. Market was giving it credit for. Over the next few years, as that proved true, other investors clambered aboard, and the company became a growth stock once
* Cyclical stocks. Some stocks, like those of steel makers or oil producers, are considered cyclical because their companies’ services or products aren’t in constant demand throughout all parts of the business cycle. For example, steel makers see sales rise when the economy heats up, spurring builders to put up new skyscrapers and consumers to buy new cars. But when the economy slows, their sales lag too. And steel stocks, which rode up on as investors anticipated the boom, ride down on expectation of the bust. Investors in cyclical stocks are typically betting on the direction of the economy.
* Income stocks. Stocks that pay
relatively high dividends, like utilities and real estate investment trusts
(REITS). Income stocks are generally favored by conservative investors
who want a steady stream of cash from their investments and count on the
dividends to buoy the stock’s price if the market takes a spill. Not all
high-dividend stocks are good investments, however. If a company’s stock
falls because of poor performance, its dividend, when expressed as a percentage
of its stock price, appears to shoot up. But if the performance continues
drag, the company may have trouble paying the dividend and be forced to cut or eliminate it altogether. In that case, the final prop for an already troubled stock will be knocked out.
If you only began investing seriously over
the last few years, you probably haven’t given dividends a second look.
After all, many of the great stocks of the early to mid '90s, like Dell,
Microsoft and Cisco, didn’t even pay dividends. And between 1990 and 1998,
the aggregate dividend yield on the Standard & Poor’s 500-stock index
fell from 3.7 percent a year to as low as 1.4 percent. Why? The simplest
explanation is that many
companies just didn't have to offer dividends in order to get investors to buy their stock. After all, what's an extra 1.4 percent when the market is posting double digit gains year after year.
Well unless our depleted ozone layer is replaced with laughing gas, the stock market won't post double-digit gains forever. And whenever that happens, dividends are likely to resume a more important role. Indeed, nearly half of the market's 10.9 percent average annual gain between 1926 and 1997 came from reinvested dividends.
Dividends can also offer a clue as to where
management thinks a company’s earnings are headed. To understand
why, consider what a dividend actually represents. Once a year, a company’s
board of directors votes to distribute a portion of its profits to shareholders.
In doing so, they are, in effect, casting a vote of confidence in the business’s
long-term earning power. If the outlook is glum, chances are they’ll cut
or eliminate it, so the company can use the precious cash for more pressing needs. But if the outlook is good, and even despite any near-term difficulties, they’ll vote to maintain or even increase the payout.