Defensive Stocks

Securities that are considered to be more stable in price in a market where prices are falling. A stock that tends to remain stable under difficult economic conditions. During market turmoil defensive stocks can provide a steady income. But what makes a stock defensive?

For example, some shares are well-positioned to withstand recession, because the goods and services they sell are essential items rather than luxuries.

Defensive stocks include food groups, tobacco companies, oil, utilities and banks are traditionally regarded as good defensive stocks, and when the market turns bearish there will be talk about a 'flight' to these kinds of stocks.

These stocks hold up in hard times because demand does not decrease as dramatically as it may in other sectors. Defensive stocks tend to lag behind the rest of the market during economic expansion because demand does not increase as dramatically in an upswing.

Defensive stocks are those to which traders flee during periods of weakness in volatile, high flying stocks. It is a stock that provides consistent earnings no matter what the state of the overall stock market is. An example of a volatile group in recent years would be high-technology.

In the most recent dictionary entry, we can find the term "cyclical stock".

A cyclical stock is a stock that does better when the economy is expanding, and worse when the economy is contracting.

An example of a cyclical company would be a car manufacturer.

Now, "defensive stocks" hold up much better when the economy is slowing or in a full-blown recession.

Why?

"Defensive stocks" are companies that don't experience a noticeable downtick in revenues when the economy goes south.

Food companies. Tobacco companies. Health care companies.

Smokers are still going to buy cigarettes in a recession. People are still going to buy dinner at McDonald's in a depression.

These are "defensive" companies, meaning - if you want to protect your portfolio in a recession, you will turn to "defensive stocks" such as McDonald's or Philip Morris.

Cyclical companies, on the other hand, will perform (by definition) poorly during times of economic distress.

The same attributes are always cited when investors attempt to define a defensive stock:

• That they are non-cyclical. That is, they produce solid earnings irrespective of the performance of the larger economy.
• That they offer higher-than-average dividend yields.
• That they are linked to either basic human needs or addictions, so defensive stocks are often connected with food and drink, power, water, health, smoking and alcohol. The 'defensive' sectors are therefore typically utilities, telecoms, pharmaceutical, beverage, food retail and tobacco.

Of course, nothing is that simple and the history of investing is littered with examples of defensive stocks which failed to conform to their "safe haven" profiles. Similarly, thorough research may unearth company characteristics in less predictable sectors which should see them safely through downturns in the wider economy.

Penny Stocks

Low-priced, small-cap stocks are known as penny stocks. Penny stocks are stocks which have a low value. Penny stocks, also known as cent stocks in some countries, are common shares of small public companies that trade at low prices per share.

Contrary to their name, penny stocks rarely cost a penny. There is no specific price that a penny stock has to be for it labeled a penny stock, however in the UK Penny stocks are often shares with a value between 1p and £1. In the US penny stocks are between 1 cent and $1.

The SEC considers a penny stock to be pretty much anything under $5. And while there are sub $5 stocks trading on big exchanges like NYSE and NASDAQ, most investors don't think of these when asked to describe a penny stock.

The term penny stock does not actually have a strict definition. One of the more common definitions of a penny stock is one which is literally priced in pennies or more specifically with a share price under a dollar. A more common definition however is that a penny stock is any stock which is priced under $5.

Another way that people define whether a company is a penny stock is according to how it is traded. This definition describes penny stocks as being those companies which trade on the over the counter market or the pink sheets. In other words, these are alternates to the traditional stock exchanges such as the NASDAQ or NYSE.

In the United States, the SEC defines a penny stock as a security that trades below $5 per share, is not listed on a national exchange, and fails to meet other specific criteria.[1] In the United Kingdom, stocks priced under £1 are called penny shares. In the case of many penny stocks, low market price inevitably leads to low market capitalization. Such stocks can be highly volatile and subject to manipulation by stock promoters and pump and dump schemes. Such stocks present a high risk for investors, who are often lured by the hope of large and quick profits. Penny stocks in the USA are often traded over-the-counter on the OTC Bulletin Board, or Pink Sheets.[2] In the United States, the Securities and Exchange Commission and the Financial Industry Regulatory Authority (FINRA) have specific rules to define and regulate the sale of penny stocks.

Penny stocks are popular because any increase/decrease in their value results in big profits/losses for the trader.

Example

• a trader invests $10,000 on two different shares, share A @ $40 and share B @$0.75 (penny share).
• share A has a value of $40 and gains 25 cents  (0.625% gain) 0.625% of $10,000 = a profit of $62.50
• share B (our penny stock) has a value of 75 cents and gains 25 cents. A 33.33% gain. A 33.33% gain of $10,000 = a profit of $3,333.33!

This clearly show that profits and losses are far steeper with penny stocks, which can represent an attractive investment for someone who needs quick money. However there are 3 major downsides when trading penny stocks;

• penny stocks lack liquidity and you may not be able to get out of a trade when you want to.
• there are schemes with penny stocks whereby someone (crooked Craig), informs everyone (people with little stock market education), to buy a specific penny share (which he already owns), then sells the penny stock after everyone he has informed to buy it, buys it. This means crooked Craig has made his profits whilst potentially leaving other people in a dangerously volatile trade.
• penny stocks can lose you money as fast as they can help you gain it, however this isn’t so much of a down side as this is the case with all investments.

Most individual investors look at penny stocks like Wall Street's Wild West, an untamed world of investing detached from all the glitz and media coverage that comes with stocks that are traded on major exchanges. While the gains and losses can be pretty impressive in the penny stock world, they're not often heard about elsewhere.
Just because you don't hear about penny stocks every day on CNBC doesn't mean that penny stocks are without drama -- take SCO Group, a software company that brought on the wrath of the world's computer-literati when it made claims to the UNIX operating system. Unfortunately, penny stocks have also garnered a reputation as a game filled with scams and corruption. Indeed, penny stocks could be your wildest ride yet as an investor.

So then, if penny stocks usually aren't traded on normal exchanges, where can you buy them?

Small Cap Stocks

You may have heard the terms small-cap, mid-cap, or large-cap in your reading about stocks and the companies that issue them. The term cap stands for capitalization and refers to the value of a company, which is a measure by which we can classify a company's size too. Big/large caps are companies which have a market cap between 10-200 billion dollars. Mid caps range from 2 billion to 10 billion dollars.

Stock is often classified by small, mid-size, or large company size. Sometimes the stocks of different-sized companies offer investors better opportunities than stock of larger or smaller firms. Understanding stock capitalization will help you make better investment decisions when put into the perspective of the economic climate in which you invest.

These might not be industry leaders but are well on their way to becoming one. Small caps are typically new or relatively young companies and have a market cap between 300 million to 2 billion dollars.

Although their track record won't be as lengthy as that of the mid to mega caps, small caps do present the possibility of greater capital appreciation, but at the cost of greater risk.

Many of us must have got mails with this headline some or the other time. And chances are that many of us must have also checked out which stock this is and invested in it! The first thing that catches our attention here is the word ‘MULTIBAGGER’. Who doesn’t want their money to multiply in a short time? Right? But, while there is a possibility that a few fortunate ones actually earn money from such multi-bagger ideas, there is also a possibility that your investment in the stock may be entirely wiped out.

The reason : Because while focusing on ‘MULTIBAGGER’, we ignored, possibly the more important word, i.e. ‘SMALL-CAP STOCK’!

Believe it or not, but the market capitalization of a stock plays an important role in deciding which stock you invest in. Choosing the best stock based on its market capitalization and your risk profile can help protect your hard-earned money and earn you great returns; more importantly it can prevent the heartburn you will get seeing your money go up in flames! But before we get into how you can do this, let’s first understand the basics of market capitalization.

If you wish to buy a company and all its shares were offered to you at the current market price, how much would the company cost you?

The answer is its Market Capitalization. Yes, you will have to pay the “Market Capitalization” of the company which is the product of a company’s total number of shares outstanding and the market price of the share i.e.

Let’s understand it with the help of an example. Suppose, you decided to purchase ABC Industries on New Year, when its shares were trading at Rs.50 and the number of shares outstanding were 1 crore. You would have paid,

Rs.50 x 1,00,00,000 = Rs. 50,00,00,000
i.e., Rs. 50 Cr. is the Market Capitalization of ABC Industries.

However, what you should remember is that the market price of a share is the public opinion about the worth of a company’s stock. Thus, Market Capitalization is the public opinion of what the whole company is worth. This opinion is based on the past performance, future prospects and market sentiments of the public about the company. The market capitalization changes with time as a result of factors like company performance, economic factors like inflation, interest rates, etc. In India, you can find companies with market capitalization ranging from a few lakh to as much as few lakh crores! As a result, companies are usually classified as large-cap, mid-cap and small-cap companies. This brings us to the next question.
 
What are Large-cap, mid-cap and small-cap companies?

We have frequently heard about some companies being Large-cap (For e.g. Reliance, Infosys etc.) while others being Midcap or Small-cap companies. Wonder how they are classified? Let’s take a look at how the BSE classifies companies according to their market capitalization.
So, what is the difference between these categories?

Market capitalization is regarded as an indicator of a company’s size. Large-cap companies are more robust. A large-cap company can be compared to a heavy goods carrier, while a midcap company to a mini carrier. If there is a speed breaker/bump on the road, the chances of a mini carrier getting knocked down are much more as compared to the heavy goods carrier. At the same time, a mini carrier picks up speed quickly and travels faster as compared to the heavy goods carrier; which requires time to catch up speed but has better stability and momentum. Given below is a comparative account of Large-cap, mid-cap and small-cap companies.

So, why should you as an investor look at a company’s market capitalization?

Let’s have a look at the Investor Meet where three good friends – Mr. Conservative, Mr. Practical and Mr. Adventurous are having dinner together:

What did u observe in the above picture?

Mr. Conservative has a very low risk appetite, so he wants to be safe and invests only in large-cap stocks.

Mr. Practical understands that if he wants high returns he must take high risk. So, he invests a part of his funds in Mid-cap stocks which increases his chance of getting a high return on his total investment. At the same time, he keeps a large part of his investment exposed to low risk by investing in large-cap stocks.

Mr. Adventurous, on the other hand, is willing to risk losing a large part of his investment, for the possibility of getting very high returns on his investments. So, he invests most of his funds in risky mid-cap and highly risky small-cap stocks; he keeps a very small part of his fund invested in large cap stocks.

Thus, market capitalization plays an important role in deciding which companies you should invest in considering your expected returns and your risk appetite.
So, what kind of a person are you? Are you Mr. Conservative, Mr. Practical or Mr. Adventurous?

Mid Cap Stocks

Generally "mid-cap" refers to stocks of companies having a market cap between $1.5 billion and $10 billion. These terms refer to a company's market capitalization, which is the number of outstanding shares times the stock's price.

Mid-cap stocks may have once been defined as large cap, but fell out of favor with investors. The thing to remember about market capitalization is that it is based on the price of one share of stock. Specific company stock returns, within a favorable market, can bump up from mid to large or dive in the other direction when conditions are reversed. Mid-cap stock performance usually falls somewhere in between the returns of their large- and small-cap counterparts.

Mid - Cap Stocks with high price momentum Shares of those companies with a market capitalization between Rs. 100 crores and Rs. 1000 crores and which have gained in-terms of price over a three - month period.

Small cap :       $250 Million to $2 Billion, approximately

Mid cap  :         $2 Billion to $10 Billion, approximately

Large cap:       $10 Billion and up, approximately

We have frequently heard about some companies being Large-cap (For e.g. Reliance, Infosys etc.) while others being Midcap or Small-cap companies. Wonder how they are classified? Let’s take a look at how the BSE classifies companies according to their market capitalization.

The 80-15-5 method:

BSE’s classifies companies according to their Market Capitalization by using the 80-15-5 method. Here’s how this method works:

• Arrange all the companies in descending order of their Market Capitalization.
• The group of companies from the top, which together contribute 80% of the total Market Capitalization are Large-cap Companies,
• The next group of companies contributing 15% (80-95%) of Market capitalization are Mid-cap companies, and
• The remaining companies which contribute 5% of Market Capitalization are Small-cap companies.

Thus, the Large-cap companies, Mid-cap companies and Small-cap companies contribute 80%, 15% and 5% of the total Market Capitalization of the market respectively. This is known as the 80-15-5 method. The number of small-cap companies is the highest followed by mid-cap and large-cap companies. Thus, a small proportion of the total number of companies (large-cap) contribute the major part (80%) of total market capitalization.

"Hard to believe papa was once a kid" goes an ad-line of a mutual fund scheme that invests in mid-cap stocks. Indeed it's hard to believe Infosys and Airtel were lesser-known companies 15 years ago. Today they are among the heavyweights of the country's two most well-known large-cap indices ' the Bombay Stock Exchange's Sensex and the National Stock Exchange's Nifty.

There are many such names which were once small or mid-cap companies but are now prominent large-cap companies that have generated very good returns over the years for investors.

EXPERT TIP: Defensive stocks help during market volatility

Fast growing economy like ours with a liberalised industrial and services sectors, the chances of finding small and mid-level companies with potential to becoming large corporations are much better than the developed economies like the US and Europe.

In this section, we try to zero in on some mid-cap companies with the potential to become large-cap companies in the next 5-10 years. We asked large brokerage houses to come out with their list of mid-cap companies that they believe have it in them to outperform others.

Large Cap Stocks

Sometimes, investment terminology is tossed around without really being explained…large-cap, small-cap, mid-cap - what exactly do they mean? The investment article published here is intended to help you get down to basics with a series of articles about the different asset classes.

First of all, let's define asset classes. They're the categories that your different investments fall into - basic ones include cash, bonds, large-cap stocks, small-cap stocks, and international stocks, though there are a number of other more specific permutations. Studies have shown that the key to successful investing is to spread your wealth among different asset classes.

Market capitalization is a term used on Wall Street that is extremely important. Although it is often heard on the nightly news and in financial textbooks, very few new investors know what market capitalization is or how it is calculated. It’s actually really easy and intuitive. After you read about the details of market cap, as it is often called for short, you’ll understand the concept and begin using it when putting together your own portfolio.

Put simply, market capitalization is the amount of money it would cost if you were to buy every single share of stock a company had issued at the current market price. For instance, The Coca-Cola Company has 2,317,441,658 shares of stock outstanding and the stock closed at $49.60 per share. If you wanted to buy every single share of Coca-Cola stock in the world, it would cost you 2,317,441,658 shares x $49.60 = $114,945,106,236.80. That’s just shy of $115 billion. On Wall Street, people would refer to Coca-Cola’s market capitalization as $115 billion.

Why is market capitalization such an important concept? It allows investors to understand the relative size of one company versus another. AutoZone, a retailer of auto parts, trades at $150.31 per share. Yet, the company’s market capitalization is only $8 billion. Despite having a stock price 3x higher than Coke, AutoZone is actually only 6.9% the size of the soft drink giant! There you can know How to Think About Share Price. In that article, you could have learn that it’s possible for a $300 stock to be cheaper than a $10 stock.

Traditionally, companies were divided into large-cap, mid-cap, and small-cap.[2] Market capitalization (or market cap) is the total value of the issued shares of a publicly traded company; it is equal to the share price times the number of shares outstanding.[2][3] Market capitalization ranks stocks into a number of distinct groups. This is important when considering an investment in a particular company.

To review, market capitalization (market cap) is a measure of the size and value of a company. To determine market cap, you simply multiply the number of the company's outstanding shares of stock by the market price of one share.

For example, let's say a company has 50,000,000 shares outstanding, and each share is currently selling for $50. The company's market cap would be 50,000,000 multiplied by $50, which equals $2.5 billion.

And why is market capitalization important? Because history has shown us that the stocks of companies with different market caps behave differently in terms of return and risk.

Because large-cap stocks have shown outstanding performance recently, you may have heard that investing in them would have been your best bet. But do large-cap stocks ALWAYS perform better than mid-cap and small-cap? Let's take a look.

Each rank has certain stereotypical features that you can look for in the stock under consideration. Mid cap stocks are more risky than large cap stocks and less risky than small cap stocks. As outstanding stock is bought and sold in public markets, capitalization could be used as a proxy for the public opinion of a company's net worth and is a determining factor in some forms of stock valuation.

The terms mega-cap and micro-cap have also since come into common use,[6][7] and nano-cap is sometimes heard. Different numbers are used by different indexes;[8] there is no official definition of, or full consensus agreement about, the exact cutoff values. The cutoffs may be defined as percentiles rather than in nominal dollars. The definitions expressed in nominal dollars need to be adjusted over the decades due to inflation, population change, and overall market valuation (for example, $1 billion was a large market cap in 1950, but it is not very large now), and they may be different for different countries. A rule of thumb may look like:

• Mega-cap: Over $200 billion
• Large-cap: Over $10 billion
• Mid-cap: $2 billion–$10 billion
• Small-cap: $250 million–$2 billion
• Micro-cap: $50 million-$250 million
• Nano-cap: Below $50 million

The total capitalization of stock markets or economic regions may be compared to other economic indicators. The total market capitalization of all publicly traded companies in the world was US$51.2 trillion in January 2007[4] and rose as high as US$57.5 trillion in May 2008[5] before dropping below US$50 trillion in August 2008 and slightly above US$40 trillion in September 2008.[5]
 
Now that we understand what market cap means, let's talk about the performance of different-sized-market cap stocks. We know that over the past few years, large-cap stocks have performed very well. For the ten years ended June 30, 1999, large-cap stocks, as measured by the S&P 500, returned an average of 18.78% per year. Mid-cap stocks, as measured by the S&P 400, returned an average of 17.87% per year for the same period. And small-cap stocks, as measured by the Russell 2000, had average annual returns of 12.39% for the same time period. So, it's easy to see that in the last decade, large-cap stocks performed the best out of these three groups.

Generally, risk of company failure decreases as the company increases in size. However, a mid cap stock also has better potential for growth than a large cap company. A very large company may have completely saturated its market, while a mid-sized company may have room to grow. So when considering an investment, you are basically trying to decide if the stock in question has the potential to grow into a large cap stock. If you are right and make the investment, you will have a successful investment.
   
The Shortcomings of Market Capitalization

There are some shortcomings to using market capitalization as a guide to a company’s size. The biggest is that market capitalization does not factor into consideration a company’s debt. In other words, in addition to having $115 billion in stock market value, Coca-Cola has $20 billion in debt. If you were to buy every share of Coke’s stock, you would own the company but still be responsible for the company’s $20 billion in debt. Thus, your “true” purchase price would be $115 billion + $20 billion = $135 billion. This figure is known as enterprise value and I explained everything you need to know about it in the article Enterprise Value – Determining the Takeover Value of a Company. There are actually some other factors that determine the difference between market capitalization and enterprise value so if you’re interested in the details, it would be worth your time to click over to those articles and take a few moments to read them.

Using Market Capitalization to Build a Portfolio
A lot professional investors divide their portfolio by market capitalization size. This approach, they believe, allows them to take advantage of the fact that smaller companies have historically grown faster but larger companies have more stability and pay fatter dividends.

Here is a breakdown of the type of market capitalization categories you are likely to see referenced when you begin investing:

• Micro Cap: The term micro cap refers to a company with a market capitalization of less than $300 million.
• Small Cap: The term small cap refers to a company with a market capitalization of $300 million to $2 billion.
• Mid Cap: The term mid cap refers to a company with a market capitalization of $2 billion to $10 billion.
• Large Cap: The term large cap refers to a company with a market capitalization of $10 billion to $50 billion.
• Mega Cap: The term mega cap refers to a company with a market capitalization of $50 billion or more.