Types of Shares and How to Choose
The jargon around shares isn’t as complex as it might seem. And once understood, it can help to make investors' lives easier.
Shares, like other investments, are notorious for jargon, starting with the mysterious titles that accompany them, which describe everything from the type of rights they offer to the characteristics of the company you’re buying a stake in.
Don’t let this faze you. The fancy terms thrown around aren’t nearly as complex as they might first appear and, when understood, they help to make investors' lives easier. Choice is a good thing, and categorisation — the process of putting classes into a group — is a useful tool to understand what we’re getting into and better match investments to our financial objectives.
When choosing where to invest in shares, consider the following:
Class of the shares
When purchasing a slice of ownership in a company, read the small print. Most companies issue only ordinary or common shares, which typically carry the right to vote at meetings and an equal portion of any earnings distributed, though there are some exceptions.
On occasion, a company may elect to sell different classes of shares that acquire or forego certain rights or privileges. Each category of share will be assigned its own letter — A, B, and so forth — and generally vary in terms of voting rights, entitlement to dividends and payouts should the company enter liquidation and its assets be sold off.
Ordinary shares can become, well, less ordinary, and adopt the following features:
- Deferred: Last in line for dividends and payments in the event of bankruptcy.
- Non-voting: Zero or very little opportunity to vote on corporate matters.
- Redeemable: The company has an option to buy back the shares in the future, perhaps within a fixed timeframe, and usually at a specified price.
To complicate matters further, companies can also issue preference shares, which don’t carry voting rights but do provide first dibs on dividends, often at a fixed rate, and a greater chance of getting paid if the business goes under. Preference shares, a hybrid of stocks and bonds, may be redeemable, convertible into ordinary shares and occasionally non-cumulative, too, meaning any right to recoup missed income payments is relinquished.
Size of the shares
Company shares are also categorised based on their total market value or market capitalisation. Size matters, and 'caps', as they are known, are typically divided into three segments:
- Large-cap: These big household names tend to have global, diversified operations, stable rather than explosive growth prospects and pay steady dividends. In the UK, large-cap shares belong to the FTSE 100 index, where market valuations range from upwards of £100bn down to £2bn.
- Mid-cap: Found in the FTSE 250, home to the 101st to 250th largest companies listed in Britain, mid-caps are often but not always more domestic-focused than their bigger peers. Being smaller usually means greater potential to adapt and change direction, resulting in a better capacity to grow – and slip up.
- Small-cap: Constituents of the FTSE Small Cap index, these companies are normally young, relatively unknown ones serving niche markets. Small-caps typically have a lot riding on one thing, fewer resources to survive a setback, and might pose liquidity issues, making it harder to buy and sell shares at their quoted price. On the plus side, if all goes to plan, and that’s a big if, they could net investors a fortune.
Strategy behind the shares
When purchasing shares, you are buying into a strategy. Each investment embodies certain characteristics, depending not only on size, but also its track record, the sector it operates in and so on. Usually, you’ll find them grouped into the following categories:
These are companies expected to increase their profits or revenues quicker than average, driven by a solid niche, limited competitive pressures, cash to fund expansion and a decent reputation for spending wisely, exhibited in metrics such as return on equity.
Growth stocks tend to be expensive. A popular way to value them, and ensure we don’t overpay, is the forward-looking price/earnings to growth ratio. To calculate this, take the P/E ratio (a company’s current share price divided by its earnings per share) and divide it by the forecasted percentage earnings growth rate over a chosen time period. The threshold is 1: anything below implies the shares are undervalued, and vice versa.
These are companies whose share prices don’t reflect their true worth. Often they’ve fallen out of favour but still have enough going for them to rally and win back investors’ hearts.
A key job for value investors is to distinguish potential bargains from shares that are cheap for a reason. Ultimately, you'd like to see a credible case for a turnaround of fortunes and sentiment, a PEG of less than 1 and reassurances that there’s enough equity to cover debt.
These are solid, dependable companies renowned for delivering consistent profits and dividend payments. Referred to as 'low beta stocks', they supply essentials such as electricity, heating, water, soap, detergent and toilet roll that are constantly in demand, regardless of their price or the state of the economy.
Steady rather than spectacular growth doesn’t come cheap, especially when interest rates are low and the economy is sputtering. You’ll want to determine that the dividend is safe and the asking price reasonable by running some tests and comparing the subject’s forward P/E ratio to its historical averages and peers.
The opposite of defensives, these businesses see their fortunes hinge on the state of the economy. Identifying them is fairly simple: What can people live without when money is tight and borrowing costs rise?
When contemplating which cyclical shares to buy, avoid those that convert little revenues into profit and have mountains of debt. Once economic activity contracts and business dries up, these types of companies could soon struggle to make ends meet. Not paying over the odds is also important to maximise returns. Often, the best way to establish a fair price for cyclicals is to start by determining its average earnings over the past decade.
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WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you
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Daniel is a freelance finance journalist. He has written and edited news, deeper analysis features, and opinion pieces for the Financial Times, Investopedia and the Investors Chronicle. Read more