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