By Mike Uzor – Financial Analyst

In stock exchanges, shares are normally classified by the various economic and industrial sectors in which the companies operate. The classification reflects the general prospects facing operators in particular economic sectors, whether they be good or bad. It does not however reflect some important qualities that bear on returns expectations and risk exposure.

Picking stocks from across industry groupings is to an extent a form of investment portfolio diversification but it may not bring out the real diversification effects on the portfolio depending on which particular stocks you buy. The purpose of portfolio diversification is to reduce risk and improve the chance of obtaining the targeted rate of return. An investor that buys penny stocks from 6 to 10 different economic or market segments isn’t likely to achieve that purpose.

The equities classification that really matters in portfolio performance is the one that differentiates stocks by some qualities that bear on risk and return. It is important to understand the characteristics of stocks in terms of their direct bearing on risk and returns prospects in constructing a share portfolio.

Investing in shares involves some elements of risk and also some stocks carry a higher degree of investment risk than others. Yet, there is no labelling of ‘high risk’, ‘low risk’, ‘sure winner’ or ‘likely loser’ stocks. However stocks show different characteristics that actually bring them to fit into this type of grouping. Understanding the risk level of a stock is the first rule in winning in the equities market.

While shares are generally riskier than money market investments they still differ widely among themselves in the degree of risk. Viewed from this perspective, there are five main categories of shares within which most listed stocks can be classified.

Blue chips

Blue chips are the shares of the big, established, market leading companies that have reached their maturity stages in operations. They and/or their products are often household names. In terms of sales revenue and profit volumes, they rank tops on the table with track records of stable dividend payment. Blue chips are usually highly capitalised and often highly priced in the stock market but they are giants that are no longer growing rapidly. That of course does not rule out a big leap in earnings once in a while. Their shares form the backborne of the large investment portfolios of institutional investors that trade equities in high volumes.

The companies usually attract a lot of attention and are the major focus of market operators and analysts. With regular information about their operations, their share prices tend to be generally more stable than those of smaller companies. Being highly priced, their share prices tend to move less rapidly or violently either up or down than those of other stocks. Price movement therefore produces less percentage changes than they do in smaller stocks.

Blue chip stocks offer the advantages of high quality and low risk, ranking next to fixed income securities in terms of stability of return. Blue chips are needed in investment portfolios for their stabilising effects on investment values. They are therefore a sensible inclusion in any share portfolio where risk is balanced with return. The benefits of blue chips can only be fully tapped by those who have reasonable amount of investment capital needed to buy a fairly large volume of the stocks.

You can expect to find equities that merit the blue chips status among the top 20 highest capitalised stocks though not all of them can rightly be taged blue chips as of now. The most important qualities that identify a blue chip are stability in earnings performance and consistent payment of dividends. The ability to post profit in both good and bad times is what makes a company’s stock a blue chip. Companies with fluctuating earnings or inconsistency in dividend payment, no matter how large they may be, do not qualify as blue chips.

The major factor that enables a blue chip company maintain stable earnings track record is large market share. With time and events however companies do lose their market shares, meaning that companies can and do lose their blue chip qualities. At present, only a few of the renowned blue chips of the 1970s and 80s still retain that status. Others that have lost their market shares are no longer able to maintain the stable earnings growth they used to.

Growth stocks

Irrespective of the economic or industrial sector to which companies belong, some companies will be growing ahead of the industry average. Growth stocks are equities of companies that are growing above the industry average numbers. They involve a different kind of risk exposure compared to blue chips.  Typically, growth companies may be in an expanding industry, an under served market or for any reason advancing market share. It could be that the company is offering a unique product or has established a technological edge that has given it access to an untapped market.

Whatever the reason may be, a growth company has a special advantage in the market it serves. This special advantage places its management in a position to achieve above average growth rates in revenue, profit and earnings per share for several years. Spotting a growth company in its infancy and taking a position early enough is a sure route to building wealth through the stock market. Some growth companies of yester years have become the blue chips of the present time.

A number of high growth companies lost their growth momentum during the global financial crisis. In the sustaining economic slowdown, hardly any companies seem to rightly fit into the growth stock classification right now. The insurance sector produced the highest number of growth stocks in the pre financial crisis period but were swept away by the crisis.

One important feature of growth stocks is that they normally trade at a stock market premium because investors will be willing to pay not only the present value of the stock but also the anticipated rapid growth in profit and the dividend in the future. The dividend yield is therefore likely to be low and the price-earning ratio tends to be high. A growth stock also has its other side in that it can slip while on the high speed and can thus crash. Should the growth momentum be lost, the high potential for profit growth will be lost as well and a once star performer may dim suddenly.

The importance of growth stocks is that they give a portfolio value a lift and therefore constitute the real power of stock market investments to beat inflation. They are an essential addition to a share portfolio but they carry a higher level of risk than blue chips against the promise of higher return. The investor needs to be at alert with growth stocks to rise with it while it is shinning and quit if it begins to dim.

An extract from How to Buy & Sell Shares in Nigeria –A Practical Guide