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How the quality of different stock types affects your investment outcomes

How the quality of different stock types affects your investment outcomes

Beginner

1st September, 10:14
Updated: 23rd September, 07:20

The level of quality and reputability you seek in a stock will likely have a major impact on the kinds of investments you make and the investing results you’re likely to achieve.

Whether you’re looking for the comfort and security that can come with investing in a well-known brand, or you’re the type of investor that looks to find the next big thing and buy-in early, you should know your way around how to assess the quality of each stock.

What are the different types of stocks as measured by quality?

When it comes to the quality of a stock, what we mean is the observable strength of that stock and its performance over time. While there’s certainly a middle ground between these two extremes, we define the two most pronounced stock types related to quality as blue-chip stocks and penny stocks. 

A blue-chip stock is one that features superior fundamental strength, a history of solid price performance, and a brand name that’s well known to investors and non-investors alike. Penny stocks are stocks that trade below $1 or £1 per share, and do not come with the reassurance that years of solid price performance and growth can give.

Why does the quality of different stock types significantly affect your investment outcomes?

Because, to stay with our extreme examples, blue-chip stocks and penny stocks usually behave very differently. 

Blue-chip stocks tend to be far less volatile than other stocks, since they’re heavily traded by big-money institutional investors and thus offer greater liquidity and stability. The tradeoff is that blue-chip stocks are less likely to suddenly rack up massive price gains in a short amount of time. 

Conversely, penny stocks offer very little in the way of interest from mutual fund managers (and by extension very little liquidity), making them often extremely volatile and also risky. This does present an opportunity if you can find the right stock, however, as a price gain of just a cent or two could result in enormous gains if you’ve bought thousands of shares for a very low price.

You should conduct an honest analysis of your investment goals, budget, and tolerance for risk before choosing either of these paths, but it’s always important to remember there are different ways you can approach stock market investing.

1) Blue-Chip Stocks

In the past, we used to associate blue-chip stocks with remnants of older-era economies, such as giant manufacturers in industries such as steel and aluminum. The term blue-chip has a broader meaning today, and can refer to any stock with an established reputation and a long track record of successful results. Stocks from any sector, including relatively newer entrants from the field of technology, can qualify. The common denominators here are quality and reputation, rather than any link to a specific sector or industry.

2) Penny Stocks

Penny stocks carry a relatively broad classification themselves, in that the only strict requirement is that they trade at less than $1 or £1 per share. That means they too can hail from any sector or industry, but they have significantly lower value than blue-chip stocks. 

There are two main reasons why a stock can trade at such a low price. The first is that they simply haven’t been discovered yet by the kind of well-heeled institutional investors with the buying power to snap up a ton of shares and push their price sharply higher. The second is that they’re simply low-quality stocks, lacking in earnings and revenue strength and/or carrying other significant deficiencies. It takes serious research to separate the hidden gems from the dregs, so make sure you take a patient and selective approach before trying an investment in penny stocks.

Here are some examples

1) Blue-Chip Stock

Few brands in the world are more recognised than Coca-Cola (KO). The soft drink behemoth has been the undisputed leader of the beverage industry for more than a century, with instant recognition and widespread consumption everywhere in the world, and the consistent fundamental growth to go with it. Like many other stocks, Coca-Cola got hammered in March 2020 amid the COVID-19 panic, before righting the ship. It’s steadily rebounded since then, and now sits just 13% off its all-time high.

2) Penny Stock

It doesn’t get much more volatile than Shiloh Industries (SHLO). The auto parts maker’s stock traded near $3.50 per share in late February, before going into a freefall, plummeting all the way to 26 cents per share on September 1. It then nearly tripled in price over the next three days. The company lacks fundamental strength and has been almost entirely ignored by institutions, so it comes with tons of risk. Still, the rocket ride that occurred in early September demonstrates how penny stocks can be very lucrative if you can find a way to nail the timing of your buy.

How do I find stock types broken down based on quality?

You can do so right where you are now. We cover blue-chip stocks on a daily basis, and also highlight certain lower-priced stocks when circumstances warrant it — but always with the disclaimer that these are risky investments to undertake.

Now that you understand how to sort and select stocks based on relative quality, it’s time to jump to the next lesson. Come along for the ride as we take you through the different sectors to consider when buying stocks.

By Jonah Keri
Jonah Keri is a trader and analyst who spent 11 years at Investor's Business Daily covering the markets. He now writes about stocks, cryptocurrencies, and other investments for Invezz and about emerging technologies for private clients.
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