What are “Equity Characteristics”?

The term equity characteristics relates to six key characteristics vis-à-vis stocks. These are size, style, volatility, location, stage of development, and type of share.

Size (also termed “market capitalization”) refers to the market value (in currency terms) of a company’s outstanding equity shares. The equity style relates to the investment style, which is the methodology or philosophy that directs an investor’s investment selection. Volatility helps define whether a stock is cyclical or non-cyclical, and whether a defensive holding or not. Location refers to the geographic positioning of a business – whether it participates in domestic or international markets. The equity stage of development categorizes stocks according to where the company is based – is it in developed, emerging, or frontier economies? Finally, investors need to know whether they are investing directly in ordinary shares of a foreign company vs. an ADR (indirect investment).

Key Learning Points

  • Categorizing stocks by equity characteristics can help the investment process and ensuring a diversified portfolio
  • Equity characteristics pertain to size, style, volatility, location, stage, and type of investment
  • The are various categories of publicly traded companies in terms of market capitalization which can help quantify the risk of investing in that stock
  • Styles can be seen both in equities and fixed income markets but may vary in importance

Size, Style, and Volatility

Size: equities and companies are generally divided into a handful of categories that can assist in the investment process. Size is likely the most commonly used equity characteristic. Companies are typically grouped by market cap and that is why size can also be referred to as “market capitalization.” This is calculated as:

Market Capitalization ($) = Total Shares Outstanding of a Company * Current Share Price.

An alternative way to calculate market capitalization is to use free float, instead of a total number of outstanding shares. In fact, many index providers such as the S&P would use the free-float method of calculating the weights for their market cap indexes.

There are several size categories of publicly traded companies: mega cap (largest publicly traded companies), large cap, mid cap, small cap, micro cap and nano cap (smallest companies in this universe and the riskiest). Their market capitalization generally ranges are:  +$200 billion, $10 billion to $200 billion, $2billion to $10 billion, $300 million to $2 billion, $50 million to $300 million, and <$50 million respectively.

Volatility: equity investments are also divided among more volatile and less volatile profiles and generally split into two major categories – cyclical and non-cyclical (also known as defensive). Cyclical stocks or industries (such as basic materials, consumer discretionary, automobile industry, financial services, and real estate) generally have a beta greater than 1. This indicates that the stock prices are more volatile than the broader market. These companies and shares are more sensitive to the overall economic cycle and to movements in the equity market.

Defensive stocks or industries (health care, utilities, and consumer staples) tend to have a beta of <1 and are less sensitive to the overall economy and market. These stocks’ profit growth and therefore its stock price tends to have a very low correlation to economic activity – no matter how the economy is performing. Further, the revenues, earnings, and cash flows of such companies remain generally stable, as does their share price. They are viewed as ‘defensive’ holdings as they are not expected to drop in price as much as the overall market when there is a downturn. Defensive companies tend to sell products that sell regardless of economic conditions – a good example is Colgate which makes toothpaste. Toothpaste sales tend not to rise dramatically in a robust economy and also sales do not tend to drop or stop in a downturn as it is deemed an essential item.

Investment Style: this helps to group stocks that share a common characteristic. Styles can be seen both in equities and fixed income. For equities, the size of the company is a major investment characteristic along with whether they are ‘growth’ companies or more ‘value-oriented’ investments. In fixed income, a major style that we generally witness is the duration/interest rate sensitivity – this gauges how sensitive bonds are to interest rates and credit quality. This can range from high yield or junk bonds to AAA-rated government securities.

For growth companies or growth investing, the revenue or cash flow growth of a company is what holds the most importance. On the other hand, value investing looks more at the stock price and specifically whether that stock price is below a fundamental value that analysts have calculated.

Other Equity Characteristics

Other Equity Characteristics include: location as international investments can be included in a portfolio to provide diversification or growth. However they come with risks such as exchange rate fluctuations, and political, economic, and social risks, so the investor must weigh up these additional factors versus a domestic investment in the home market. Equities can also be categorized into stages:  these are typically categorized as developed, emerging, or frontier economies – which are a subset of emerging markets. The third other equity characteristic is a type of investment.  This helps evaluate whether to make a direct investment in ordinary shares of a foreign company or to purchase an ADR (American Depository Receipt) or similar which is classed as an indirect investment.