Stock Classifications (Part 2)

To continue with the different ways in which stocks are classified...

Sector/Industry

Different data sources segregate businesses into a variety of sectors. I’ll be using the sector classifications from Morningstar.com, which is a well-known source for data on mutual funds. Morningstar uses eleven broad sector classifications which it breaks into three "super sectors."

Cyclical Super Sector: Includes industries “…significantly impacted by economic shifts. When the economy is prosperous these industries tend to expand, and when the economy is in a downturn these industries tend to shrink.” [Source:  www.morningstar.com] There are four sectors included in the broad cyclical category.

1. Basic Materials: Companies that manufacture chemicals, building materials and paper products. This sector also includes companies engaged in commodities exploration and processing. 
2. Consumer Cyclical: Retail stores, auto and auto parts manufacturers, companies engaged in residential construction, lodging facilities, restaurants and entertainment companies. 
3. Financial Services: Companies that provide financial services which includes banks, savings and loans, asset management companies, credit services, investment brokerage firms, and insurance companies 
4. Real Estate: Mortgage companies, property management companies and Real Estate Investment Trusts. 

Sensitive Super Sector: “… includes industries that ebb and flow with the overall economy, but not severely so. Sensitive industries fall between the defensive and cyclical industries as they are not immune to a poor economy, but they also may not be as severely impacted by a poor economy as industries in the Cyclical Super Sector.” [Source:  www.morningstar.com] The four broad sensitive sectors are:

1. Communication Services: Companies that provide communication services using fixed-line networks or those that provide wireless access and services. This sector also includes companies that provide internet services such as access, navigation and internet related software and services. 
2. Energy: Companies that produce or refine oil and gas, oil field services and equipment companies, and pipeline operators. This sector also includes companies engaged in the mining of coal. 
3. Industrials: Companies that manufacture machinery, hand-held tools and industrial products. This sector also includes aerospace and defense firms as well as companies engaged in transportation and logistic services. 
4. Technology: Companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services. Also includes companies engaged in the manufacturing of computer equipment, data storage products, networking products, semiconductors, and components. 

Defensive Super Sector: “… includes industries that are relatively immune to economic cycles. These industries provide services that consumers require in both good and bad times, such as health care and utilities.” [Source:  www.morningstar.com] The three broad defensive sectors are:

1. Consumer Defensive: manufacturing of food, beverages, household and personal products, packaging, or tobacco. Also includes companies that provide services such as education & training services. 
2. Healthcare: biotechnology, pharmaceuticals, research services, home healthcare, hospitals, long-term care facilities, and medical equipment and supplies. 
3. Utilities: Electric, gas, and water utilities. 

Some people believe certain sectors might outperform other sectors at a specific point in time. Some mutual funds focus only on specific sectors. For instance, here are some different mutual funds that focus on the Technology sector:

• Fidelity Select IT Services Portfolio (FBSOX)
• USAA Science and Technology Fund (USSCX) 
• T. Rowe Price Global Technology Fund (PRGTX) 

It is possible to find mutual funds that focus on each of the eleven sectors. If you wanted, you could invest all your money in a sector that you believe will outperform the overall market; however, this is an extremely risky strategy.

A heatmap (finviz.com) of the S&P500 that is broken into sectors (and to some degree, industries within sectors) is shown below. This heatmap is for the past month. You can see that the UTILITIES sector has not performed well compared to the other sectors.

The overall stock market is not weighted equally in terms of sectors. For instance, the market cap of companies in the Technology sector is the highest, while the market cap of companies in the Utilities sector is the lowest. This changes over time, as the market cap of companies change. 

Developed vs Emerging Markets

A developed economy is one that has a high level of economic growth and security. Stock in companies that are based in a developed economy are said to trade in a developed market (DM). DMs have a high level of financial regulation, and investors have easy access to publicly-available information. Countries with DMs include the U.S., Canada, England, Japan and most of western Europe.

Emerging markets are markets in countries that do not have the same level of economic security and growth as developed markets. The political climate and exchange rate system may be highly unstable. The country may have only recently moved from a closed economy to an open-market economy. Civil wars may still erupt. The country may be receiving a large amount of donations from other countries. However, growth in these countries may also be high.  

Investing in stock in companies in emerging markets is riskier than investing in stock in developed countries. The following graph shows the returns for the MSCI Emerging Markets Index (an index of stocks in over 800 companies from 23 emerging market countries), the Russell 2000 Index (an index of the 2,000 smallest companies in the Russell 3000 Index—all of them based in developed countries) and the S&P500 (an index of 500 large U.S.-based companies). (Source: Callan Periodic Table of Investment Returns).

You can see that the returns of the emerging market index have higher peaks and lower valleys than either of the other two indices. The volatility of emerging market returns is greater than the others. From 1993 to 2013, the MSCI Emerging Markets index generated a higher average annual return (13.87%) than the other two indices, but the risk was much higher, as shown below.

You might think, “Wow, with average annual returns of 13.87%, I would be willing to accept nearly twice the risk of developed market returns.” The “average return” from the table above only takes each year’s return from the graph and calculates the arithmetic mean—by summing the annual returns and dividing by the number of years. It is NOT a cumulative measure. For a better understanding of what I mean, review the numbers in the table below. These values represent how much a $10,000 investment made in 1993 in each of the three indices would be worth at the end of 2014.

Even though the MSCI Emerging Markets Index had the highest average annual return, the ending value is the lowest of the three.  Thus, the average annual return (arithmetic mean) is not the best way to measure your return on an investment.  The best mean return measure to determine one’s annual change in wealth is the geometric mean. The geometric means for the three indices are:

Although the geometric mean for each index is below the index’s average return, it is the extreme volatility of the MSCI Emerging Markets index that causes its geometric mean to be so far below its average return—making its cumulative change in wealth lower than the other two indexes.

This doesn't mean you should exclude emerging markets from your investment portfolio.  Emerging markets have an interesting quality that I will discuss in a later post.

Next up:  I had originally intended to only include two posts on Stock Classifications; however this post is quite long already.  I'll finish the Stock Classifications post next week and the following week I will analyze several equity mutual funds in terms of all the different classifications.

Stock Classifications (Part 1)

Why am I discussing ways to classify stocks? Because, to understand an equity mutual fund, you need to understand its investments, at least in a broad sense. Many equity mutual funds focus on specific stock classes, although many mutual funds also diversify across stock classes.

There are a variety of ways to classify stocks. I’ll be discussing the main ones.

Size of the Company [AKA: Market Cap(italization)]: The size of the publicly-traded company is one popular classification method. In this case, the size is measured by taking the company’s current stock price and multiplying by the number of outstanding shares of common stock. A company’s market cap is widely available on nearly every stock quote service. Figure 1 is an example of Apple’s stock quote (Apple’s ticker symbol is AAPL; a ticker symbol is the identifier for a specific company’s common stock) from finance.yahoo.com. I've highlighted the market cap in yellow.

Figure 1
Source:  finance.yahoo.com

You can see that at the time I screenshot this quote, AAPL’s market cap was $745 billion. It was calculated by taking the current price per share of common stock of $127.83 and multiplying it by the number of common shares (a value not shown in the screenshot).

There are five common market cap categories, although some include a sixth while others only segregate into three (large, mid and small). The six categories and their current dollar values are:

*The dollar value for each category changes over time.

**some omit this category and just say micro = Less than $300 million

Thus, AAPL’s common stock would currently be classified as a Giant Cap. GoPro’s stock [see Figure 2], with its market cap of $6.46 billion would be classified as a Mid Cap. In October 2014, GoPro’s stock was trading at about $94 per share, making its market cap about $12 billion, or a Large Cap stock. Over five months its stock price has dropped so that it is now classified as a Mid Cap. Of course, if GoPro’s stock price rises substantially, it could eventually be classified as a Giant Cap.

Figure 2
Source:  finance.yahoo.com

Stocks are classified by market cap because historically (over the long run), smaller cap companies’ common stock have generated higher returns than larger cap companies’ stock. This a generalization and it is not always true. You can find some giant cap companies that generate higher returns than some small cap companies and vice versa. During some time periods small cap stocks as a group will underperform large caps stocks as a group. But, generally, over the long run small caps have generated an annual return in excess of large caps at a cost of higher risk. Small caps are typically far more risky than large cap stocks. The table below shows the returns for two different indexes. The Russell 2000 is an index (a collection) of 2,000 smaller cap stocks and the Russell 1000 is an index of 1,000 larger cap stocks.

The standard deviation (SD) is a measure of risk. It measures the deviation about the average return. Since the Russell 2000 tends to have more volatility than the Russell 1000, it has a larger SD. You can see that small caps generated higher returns, on average, over the past ten years, but they did so with higher risk. If I were to use a much longer time period, the difference in return and risk would be far greater.

Geographically: Another common way to classify stocks is by country/region. Not all companies in all countries perform identically. For instance, in 2007, at the beginning of the most recent large financial crisis, the Standard & Poor’s 500 index (a collection of 500 companies that measures the broad U.S. stock market for giant, large, and mid cap companies) earned a return of 5.49%. However, that same year the MSCI Emerging Markets index earned a return of 39.78%--quite the difference! The next year when the bottom fell out of the market, the S&P500 Index lost 37% while the MSCI Emerging Markets Index lost 53.18%. The MSCI Emerging Markets Index is an index that contains about 2,600 companies from 23 countries that are considered to have emerging markets. [As I mentioned in last week’s post, emerging markets are those where financial regulations are not as strict as in the U.S., the political and economic environment is rather unstable, etc.] Countries in the MSCI Emerging Markets Index include China, Brazil, Indonesia, Mexico, and Russia.

A website I enjoy for its graphic displays (called heatmaps) is FINVIZ.com. [Stockmapper also has some neat heatmaps, but for my purposes today FINVIZ shows what I want to demonstrate better.] Below is an example of a heatmap for the S&P500 (again, a measure of the U.S. market for larger cap companies) for Friday, February 19, 2015.

The legend is in the bottom right corner. The rectangles contain the Ticker Symbol for a company’s common stock as well as the return the stock generated that day if the rectangle is large enough. The larger the rectangle, the larger the market cap of the company. The brighter the green (red), the higher (lower) the return. Obviously, given the variety of colors in the heatmap, not all companies in the S&P 500 performed the same. Wal-Mart (WMT) lost 3.21% while Facebook (FB) gained 3.53%.

Here’s a heatmap for the world for the same day. Overall, it looks like stocks for companies based in Japan had a pretty good day, while Brazilian companies did not.

Here are the same two heatmaps, but the data is for an entire year, rather than a day. Generally, larger company stocks have had a good year in the U.S.  Notable exceptions are Google (GOOGL) and IBM as well as a cluster of smaller companies in the Basic Material sector.

S&P500 Heatmap for past year

From the world heatmap we can see that India and Taiwan have had a good year, although Germany isn't doing well, nor is Luxembourg. [These maps are perhaps more interesting if you go to the FINVIZ website, where they are interactive. However, the data won’t be identical to the ones I have posted as it will be for a new time period.]

World Stock Heatmap for past year

By investing in stocks all over the world, we can diversify our portfolio more than just investing in stocks from only the U.S. This can help reduce our risk, since all the stock markets across the world do not move perfectly in tandem.


Next week: More ways to classify stocks (sector and industry, value and growth, developed vs emerging, dividend-paying vs non-dividends)

The following week: Analyze an equity mutual fund and review how diversified it is across various stock classes

What is a Mutual Fund?

What is a mutual fund?

A mutual fund is an investment that uses money from many investors (like you and I) to purchase a mix of securities, such as stocks, bonds, and money market instruments. The fund is managed by a single person or a group of people. As an investor in the fund you will pay a fee for the managers’ services and there may be other fees as well. Fees will be the topic of another post. Many companies have mutual funds, including Vanguard, Schwab, T. Rowe Price, Fidelity, and Blackrock. I have only listed a few! There are literally tens of thousands of mutual funds.

Fund Types

A mutual fund may diversify across different types of securities—for instance, it may own both stocks and bonds (called a hybrid fund), or it may focus only on stocks (an equity fund) or only on bonds (a bond fund) or only on short-term debt instruments (a money market fund). Funds may also specialize in a specific type of security. A small-cap emerging market fund will focus on smaller companies in emerging markets. An emerging market is one that isn’t as advanced as say, the U.S. or Japan. The reporting regulations may not be as strict or well-developed and the country may have only recently developed a stock exchange.

Fund Objective

Each fund must list its objective in its prospectus, which is a document the fund must provide investors explaining their fees, objective, investment strategies, risks, etc. This information can also be found online, either at the fund’s website, Morningstar.com and finance.yahoo.com. As an example, this is the objective for the Vanguard 500 Index fund:

The investment seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The fund employs an indexing investment approach designed to track the performance of the Standard & Poor's 500 Index, a widely recognized benchmark of U.S. stock market performance that is dominated by the stocks of large U.S. companies. It attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.  Source: finance.yahoo.com

Some years ago there was a movement toward socially responsible investing [SRI] (and there are still many who are interested in this type of investing). SRI involves not investing in companies that generate revenue/profit by engaging in what you may consider irresponsible activities, such as gambling, tobacco use or drinking alcohol. Eventually, a mutual fund was started that ONLY owns stock in companies that operate in the “vice” industries of gambling, tobacco, alcoholic beverages and defense. The fund is USA Mutuals Barrier Investor (VICEX). [The symbol VICEX is the identifier for the USA Mutuals Barrier Investor fund. If you are looking up information about the fund online, you can type in the symbol rather than the entire name. Since I research many mutual funds the ability to search by symbol rather than name is a time saver.] Below is VICEX’s objective:

The investment seeks long-term growth of capital. Under normal market conditions, the fund will invest at least 80% of its net assets (plus borrowings for investment purposes) in equity securities of companies that derive a significant portion of their revenues from a group of industries that have significant barriers to entry including the alcoholic beverages, tobacco, gaming and defense/aerospace industries. It will concentrate at least 25% of its net assets in this group of barrier to entry industries (but no more than 80% of its net assets in any single industry).

Active vs. Passive

A mutual fund can either be actively managed or passively managed. An actively managed fund is one where the manager believes he can, by conducting research, find securities that will outperform the overall stock market in the near future. He’ll buy those securities for the fund (that is called “going long”). He may find securities that he believes will underperform the overall stock market, in which case he may sell (or “short”) those securities with the intention of buying them at a later date once they have fallen in value. This may be the topic of another post. Regardless, an actively managed fund requires that the manager do more work; thus, the fund charges investors a higher fee. VICEX is an actively managed equity fund--its management fee is 0.95%.

A passively managed fund is designed to emulate an index, such as the Standard & Poor’s 500. Perhaps the most famous index fund is the Vanguard 500 Index (VFINX). You can see from the objective I posted above, that its goal is to track the performance of the S&P 500.  As the process of choosing investments is limited by the index the fund is emulating, it is not as difficult to manage an index fund.  Therefore, the management fee for index funds is generally rather low.  The management fee for VFINX is 0.15%.

As this is only my first post, obviously I have a lot more to say!  As the weeks progress I will add posts about why we should consider mutual funds as investments, the fees a fund charges, how to tell how well diversified a fund is, how risky funds are, and what types of returns do funds generate, among other things.