Differentiating Growth, Defensive, Speculative and Cyclical Types
Identifying which companies are the pick of the litter and determining whether the intrinsic value of their stocks is above or below required rates of return.
Although it may not appear as a clearly drawn line, there is a difference between analyzing a company and evaluating its stock.
Generally, company analyses require not only examining key fundamentals, but also evaluating them within the overall economic and industry contexts, while stock evaluations involve determining stocks’ intrinsic values and identifying which are overvalued and which are undervalued compared to their respective risk levels.
On the Growth Path
Historically speaking, growth companies have been defined as those that managed to post consistent above-average revenue and income growth rates.
The problem with this perception, however, lies in the management’s ability to manipulate both figures through various, though quite legal, accounting procedures.
A much better definition of a growth company sees it as the company whose management has been able over time to post returns well above the company’s required rate of return, which is its weighted average cost of capital, or WACC for short.
So, a growth company would be the one that is able to obtain capital, either through borrowing or stock issuance, at, let’s say eight percent, and then turn around, invest that same capital, and obtain much higher returns on its investments of 15% or more.
Clearly, such a company would be able to grow its business faster, collect larger revenues and report above-average earnings on its financial statements.
Note, however, that stocks of growth companies are not necessarily also classified as growth stocks.
Generally, growth stocks are those that have the ability to generate greater rates of return than other stocks operating in the similar market environment and/or industry.
If a stock is undervalued by the overall market and compared to its “peers,” it might be able to post higher rates of return when market participants realize the stock is “flying well under the radar.”
So, temporary “glitches” in the distribution of market information will cause the market in the stock to be inefficient. Of course, the moment buying pressures ensue, the stock’s price is likely to adjust upward and correct any existing inefficiencies.
Being on the Defensive
Typically, defensive companies expect their future earnings to come under fire during economic downturns and thus have the urge to be on the defensive by lowering their business risks and limiting their financial risks. Examples of defensive companies are utilities or public grocery chains.
As far as defensive stocks are concerned, those are the stocks that are not likely to suffer much when the overall economy slows down or declines. This is because such stocks would have low exposure to systematic risk, as expressed in the CAPM valuation model.
So, when the bear rears its ugly head, defensive stocks are less likely to suffer because the impact of the overall market risk is relatively limited.
Riding the Cycle
When business cycle takes a turn, cyclical companies get dragged along for the ride (steel, auto and heavy machinery manufacturing).
During economic expansion, such companies enjoy better-than-average performances, while the opposite happens when the economy contracts.
Obviously, cyclical companies’ earnings are volatile as a function of sales fluctuations and increased operating leverage, both of which only become exponentially more volatile due to increased financial risk.
A cyclical stock is the one whose rate of return would experience larger swings away from the overall market returns. In the context of the CAPM valuation model, the cyclical stock would have a much higher beta than the benchmark market used in the model.
Speculate at Your Own Risk
Finally, speculative companies are defined as not only having assets that expose investors to above-average risks, but also potentially offer above-average returns, such as, for example, oil and gas exploration companies.
There are also speculative stocks, which are defined as stocks that exhibit high probability of negative returns and low probability of posting above-average returns.
Typically, a speculative stock is overpriced, which could mean that the market is likely to adjust that price downward to reflect its actual market value.
What Does it Mean to Investors?
Simply, when analyzing a potential investment, consider both the company and its stock. Determine first what type of company you are dealing with.
Then, use that information as a backdrop for your valuation models. Once you have determined the stock’s intrinsic value, compare it to its market price.
The rest is pretty much self-explanatory. That is, if you have identified an undervalued growth stock that offers a rate of return at or above its risk exposure, you may have found yourself a winner!