Types of stocks and their risk profiles
Most equity portfolios are classified in two ways:
- By size, or market capitalisation, of the companies whose stocks are invested in by the portfolios
- By risk profile or valuation of the stocks
Market capitalisation of investments
The market capitalisation (also known as “market cap”) of a company refers to the company’s total value according to the stock market. It is the product of the company’s current stock price and the number of shares outstanding.
For example, a company with a stock price of £10 and 10 million outstanding shares has a market cap of £100 million.
Companies (and their stocks) are usually categorised as small-, mid- or large capitalisation. Most equity portfolios focus on one type, but some invest across market capitalisation.
Examples of large cap companies can be found on the FTSE 100 index, whereas indices such as the FTSE Small Cap Index or the Hoare Govett Smaller Companies Index list the small caps.
Whereas there is no real answer and definitions vary, small capitalisation typically means any company worth less than £1 billion. Mid-caps usually have a market value in the £250 million to £2 billion range, whereas large-caps can be valued anywhere from £2 billion upwards.
As would be expected, large capitalisation stocks primarily constitute well-established companies with long-standing track records. Although this is generally true, the tremendous growth of new technology companies over the past decade has propelled many fledgling companies into the ranks of large-capitalisation.
For instance, Google has a market-capitalisation of around $149 billion and is one of the largest companies in the world. In the same way, small and medium capitalisation stocks not only include new or underrecognised companies, but also sometimes include established firms that have struggled recently and have seen their market caps fall.
Recently, fund investing in new capitalisation categories has emerged: for example, the “micro-cap” (under £150 million) and “mega-cap” (over £35 billion) funds, each with the stated objective of investing in very small or very large companies.
Risk profiles: “value” vs. “growth” investing
Equity portfolios invest in either “value” or “growth” stocks. These terms are also tied in with expected risk: a “growth” stock can provide higher returns and more risk.
There are many ways that investors define these styles, but most explanations focus on valuation. Value stocks can be characterised as relatively well-established, high-dividend paying companies with low price-to-earnings and price-tobook
Essentially, they are “diamonds in the rough” that typically have undervalued assets and earnings potential.
Growth stocks (or “glamour” stocks) have the potential to expand at rates that exceed their respective industries or market. These companies have above average revenue and earnings growth and their stocks trade at high price-to-earnings and price-to-book ratios. Technology companies such as Google and Apple are good examples of traditional growth stocks.
Many variations of growth and value portfolios exist in the marketplace today. For instance, “aggressive growth” portfolios invest in companies that are growing rapidly through innovation or new industry developments. These investments are relatively speculative and offer higher returns with higher risk.
Many biotechnology companies and new internet stocks in the late-1990s would have been classified as aggressive growth. Another classification is a “core stock” portfolio, which is a middle ground that blends investment in both growth and value stocks.