3 Simple Stock Categories

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I am sure I have mentioned a few times before how I really struggle with this idea of ‘Growth Stocks’ and ‘Value Stocks’ and my whole beef is really around the idea that a Growth Stock doesn’t need to encompass the concept of Value and that Value Stocks really seems to be lazily used to describe Stocks with a large Dividend Yield. Of course the idea that all Stocks with chunky Yields represent value is silly because they could just as easily be flagging a big problem and actually be a ‘Value Trap’.
 
‘Value Trap, utter Cr*p.’
 
I was thinking that had a bit of a rhyme to it and then I remembered a joke from the comedian Tony Hawks (he’s on Radio 4 a bit but most people probably won’t know him – apart from the book ‘Round Ireland with a Fridge’ which is very good), where he talks about when he had a minor hit record as ‘Morris Major & the Minors’ probably in the late 1980s and it was called ‘Stutter Rap’. Anyway, he was on about reviews it had got and some wag in a Music Paper of the time had the written the headline; ‘Stutter Rap, Utter Cr*p’.

​Where was I? Ah, the idea that Growth Stocks don’t have a value consideration is plain silly because even a piece of highly speculative AIM Garbage can be classified as a ‘Growth Stock’ but it clearly doesn’t represent value because it is essentially rubbish and worth less than zero.
 
When you get a Growth Stock even if it is actually a decent and properly growing Company, you can’t just blindly bid it up to the moon and you need to consider the valuation if you are to buy into it. In addition to this, when you properly consider the valuation aspect of a Growth Stock this will help you size your Position accordingly and if something is on a stretched valuation then you are best off buying a small position because that helps control Risk and you can always buy more later if it drops back but is still a good business or if it beats expectations and is in fact cheaper than it first appeared.
 
To value a Growth Stock you need to think about the PEG Ratio – this is the Price to Earnings Ratio (the infamous P/E) divided by the percentage growth rate in the Earnings. The ideal situation for something to look ‘cheap’ is for the PEG to be below 1.0 and a PEG higher than 3.0 or more is probably getting expensive. I will include a link at the bottom of this blog to one I did ages ago about how to value stuff.
 
In ‘Investors Chronicle’ magazine the excellent Chris Dillow does an occasional piece about various different strategies and how they have performed over time and uses the nifty device of 6 theoretical Portfolios all drawn from the FTSE350 and holding 20 Stocks. The categories he uses are roughly the following:

• Momentum Stocks (the biggest risers in the previous year).
• Defensive Stocks (Low Volatility Stocks - I think this is based on low Beta, which is the degree to which a Stock moves in relation to the overall Market).
• Value Stocks (defined as the highest dividend yields).
• Negative Momentum Stocks (the biggest fallers in the previous year).
• High Volatility Stocks (I think this is based on high Beta, which is the degree to which a Stock moves in relation to the overall Market).
• Mega Caps (defined as the biggest 20 Stocks in the FTSE350).

 
Anyway, I was thinking about all this the other day and as I boiled it down I came to the idea that perhaps there are really just 3 categories for Stocks that really matter, and they are the following:

• Momentum Growth Stocks
• Recovery Stocks
• Income Stocks.

 
What I am getting at here is that it’s perhaps these 3 types of Stocks that really matter to us as Private Investors and if we go through our Portfolios and allocate one of these categories to each of the Stocks we hold, then anything that falls outside of these perhaps isn’t worth holding. An alternative way to consider it is that any Stock outside of these definitions is probably going to not do much for ages and even if we accept a few in a large diversified Portfolio, we probably don’t want too many of them.
 
Here is more definition on each type of Stock as I see them:
 
Momentum Growth Stocks
These show growing Revenues, Profits, Cash Generation, Dividends etc. In addition, not only does the underlying Business have clear signs of growth, the Share Price also has Upwards Momentum as best shown with a long-term Uptrend Channel on a 3 year or 5 year Chart or something like that. This is obviously a business that is growing in every sense of the word. Examples I would suggest are things like Iomart IOM, Boohoo BOO, Team17 TM17, Paypal PYPL etc. You perhaps could include Ocado OCDO but of course you start getting into valuation concerns with that one as the PEG looks very unimpressive.
 
Recovery Stocks
These are Stocks that have gone ‘wrong’ for a period of time and in many ways are probably my favourite type of Stocks. What we are looking for here are Quality and established Companies that have gone off the rails a bit but fundamentally there is something good underneath and it is just a temporary problem that can be ‘fixed’ in time with some Restructuring surgery; and often just going back to the basics is what is needed.
 
The common factor I see in pretty much every proper Recovery Stock is that the Recovery starts when a new CEO arrives and preferably a total clear-out of the top team occurs. There are various reasons this change at the top makes the difference but it is probably mainly because the existing management are a bit tied emotionally and politically to the way things are already being done (which we know is badly !!) and a new set of bosses doesn’t have this legacy to hold them back from making tough decisions and swinging the axe where it is needed. They are not restrained by internal politics and cultural norms.
 
The golden rule on such potential Recovery Stocks is not to buy them until the Recovery is clearly underway and you really want a clear sign that the Price Chart is breaking higher above previous Resistance and that upwards momentum is starting. If you think something you do not hold could be a good Recovery play, then the trick is to buy a little bit early on so you are not taking too much risk if it goes bad again and by taking a ‘Starter Position’ you are in the game and it means you will be watching it.
 
It is all too easy to forget about a potentially excellent Stock when you don’t have a holding in it – there are so many distractions and so much noise to navigate. Once the Price is moving higher and the Turnaround has clearly started in the news coming out of the Company, that is the time to buy more, assuming the Valuation case still stacks up.
 
The other really useful technique if you are holding a Stock that has ‘gone wrong’ for a while, is to ‘Average Down’ by buying more but this can be very dangerous if the Share Price is still falling (in a Major Downtrend Channel) and, like I mentioned above, the time to buy more is when the Share Price is clearly breaking upwards and there is positive momentum in the news coming from the Company.
 
Ideally a potential Recovery Stock will have a strong Balance Sheet with Net Cash and if it pays a decent Dividend then it, in effect, ‘washes its face’ while you patiently wait for the true Recovery phase to kick in.
 
Mpac MPAC is clearly an example of a Recovery Stock and this is one I averaged down on and others such as Bloomsbury BMY and Avon AVON were troubled companies that eventually turned around and became big winners for the lucky holders.
 
Income Stocks
These are ones where you are not really holding them for a Recovery and you are not holding them because they exhibit Growth characteristics, but because they pay a sizeable and reliable Dividend and you see them as long-term Holds and they are very much ‘do nothing’ positions that you don’t worry about much and you accept a lower overall Rate of Return on the Portfolio because you are really not doing much to it. This is very much the essence of my Income Portfolio and if you skip over to the ‘Portfolios’ page on my WD1 website then you can see more details about this.
 
Having part of your overall Portfolio parked in such an Income Approach has the added benefits of adding to overall diversification with something likely to be more defensive and to hold up better in tough times, and it also means more diversity across Approaches and effort involved with managing your Stocks.
 
Of course, for people who want to pick up Income in regular Cash Payments for actual day-to-day spending, taking such an approach to part of how you manage your Stocks can be really helpful and make things a lot easier than having to worry about which Shares to sell each Month when you are desperate for some Cash so you can go down the Slug & Lettuce.
 
Note, there is some crossover between these types. This is best shown with what could arguably be classified as a Recovery Stock but which also looks like a Momentum Growth Stock – Games Workshop GAW or Future FUTR are good examples of this crossover. In reality it doesn’t matter which Box you drop them in – the fact is whether they can be classified as Momentum Growth or Recovery, you want to be holding them.
 
You can also have Income Stocks that exhibit traits of a Growth Stock or a Recovery Stock – from my own Income Portfolio I would say AstraZeneca AZN is a bit of a Growth Stock and Vodafone VOD could be a potential Recovery Stock. Both of these had chunky Dividend Yields when I bought them for the Income but whereas VOD still has a good Yield, the Share Price on AZN has run up a lot and now the Yield is not so great, but I am happy to hold on.
 
Practical Implications
Anyway, what is the point of all this? Well, maybe using the 3 Classifications of Momentum Growth, Recovery and Income to organise the Stocks we hold in our Portfolios could be a very useful and quite easy to do exercise. It is simple and that is always a good thing.
 
The essence of it is that we can work through each of our Stocks and place them in the appropriate Basket and apart from making us think about what we hold and why we are holding it, it is also likely to mean that we end up with a group of Stocks that don’t fit any of these categories. As a very simplistic and rigid method of dealing with these outliers, we could just be really strict and say that any that don’t fit a Category have no point being in our Portfolio and we can chuck them out by selling as soon as possible.
 
However, Stocks which do not fit the classification could be worth holding if you really think they can Recover or if they don’t qualify as Momentum Growth or Income but you think they could morph into one of the 3 categories; but it is also worth thinking about a likely timeframe for this to happen – because if it is going to take years and years then maybe you would be better off dumping it. Getting rid of such a Stock would free up a bit of Cash which might not amount to much on its own but when combined with Cash from other Stocks you sell in the course of your normal activities, it might be worthwhile.
 
It might also free up a ‘Slot’ for another Stock that you would prefer to hold and which would fit in one of the 3 Categories. Holding a few of these in small quantities (whether by design or because they went ‘bad’ on you !!) might be reasonable but you don’t want too many because they can be very frustrating (I know because I am holding a few like this !!)
 
In addition, when looking to buy a New Stock for your Portfolio, using the 3 Categories and deciding which Bucket it sits in might help you decide whether or not you really want to buy it. For example, let’s say you have 60% of your Stocks in Growth Momentum and 25% in Income and 15% in Recovery – you might decide that another Growth Stock is not really what you need and you might choose to pass on that one and look for something that is more of a Recovery play. It is up to you how you apply these Categories etc.
 
I hope that has oiled your grey matter and got you thinking – give it a whirl on your own Portfolio as it might make a difference or help you take some tough decisions that you have been putting off.
 
Regards, WD.
 
 
Related Blogs
This Blog Series covers pretty much everything on how to value Stocks. There are links to the first 3 parts at the bottom of this one:
 
https://wheeliedealer.weebly.com/educational-blogs/valuation-valuation-valuation-bursting-for-a-pe-part-4-of-4
 
This one covers the thorny subject of ‘Averaging Down’ and the do’s and don’ts:
 
https://wheeliedealer.weebly.com/educational-blogs/is-averaging-down-the-root-of-all-evil