Most of us think of the stock market as a monolithic entity.  I don’t.  I believe it has an internal structure of three categories each based on the size and history of the companies.   Or sometimes, it’s just the nature of the business.   Each segment has its own investment advocates.  

The first segment is based on the historic reason for investing.  Income.  The investor receives a share of a company’s profits as a quarterly dividend.  The stock’s current value is then based on the dividend discount model which takes the value of all expected future dividend payments discounted back to present value.  Today this approach works best with utility and real estate investment trusts.

 It’s used by investors who are looking for a consistent return. This was especially prevalent from 1929 to 1955 and is still used.  The focus on dividends had been created by the crash of ‘29.  However, the effect of rising interest rates on dividend yields may not be realized by the current generation.  After all, the last time rising interest rates occurred was 37 years ago!

The second structure is represented by large capitalization “blue chip” companies.  The term derives from the game of poker.  A blue chip denotes the highest value in the game.  Such is the respect the investment community holds for this market segment.  Because of this sense of elitism, its investor base is primarily with conservative investors.  These large capitalization companies represent an investment “menu” that bank trust companies, and other fiduciaries, use for their clients. 

However, banks are definitely not in the performance business.  They see their purpose as fiduciaries providing investment security.  Hence, they buy names everyone knows.  Companies such as Proctor & Gamble, Colgate Palmolive, and IBM etc. are representative.  Of course, these are mature companies that are impacted by global macro events.  Since the companies are large, they represent the components of the S&P 500 and contribute to the popular perception of the market as a monolithic entity. This is especially so given the growth of ETFs and index funds the past 10 years. 

But again, it is not. This is because businesses go through a bell curve of growth and decline just as we do.  There is birth, then a period of rapid growth followed by a slowing maturity (large cap blue chips) and ultimately death.  Years ago a client brought me a Standard & Poor’s stock guide from the 1920s.  As I looked through it, I was startled to realize there weren’t any names that that I knew.  Because of my youth, I had assumed companies “lived” forever.  The stock guide impacted my perspective.

Having an awareness of the life cycle of a business led me to work for small investment banking firms.  After all, they financed the left side – the growth side - of the corporate bell curve.  This third internal structure of the market was where I wanted to focus.  Growth stocks have the advantage of being able to be oblivious to whatever is the current economic environment.  They’re small and idea driven.

That reality was clearly demonstrated during the economic stagnation of 1965-1982.  It was a time of war (Viet Nam) and high inflation (fed funds went from 4.5% to 20.5%).  The stock market went sideways for 17 years.  Yet, it was also a time of growth stocks such as Wal-Mart, NIKE, Toys R Us, Microsoft, Oracle, McDonalds, Holiday Inns and many others.   During those 17 years, the average mutual fund - the principle buyer of growth stocks - outperformed the S&P by 3.5% a year.  Investors learned finding a small growth company, run by an entrepreneur who owned significant stock, could make them a lot of money.  Especially if it is in a large and highly fragmented business and is, or could, become the dominant company.  If net income is growing faster than sales – the opposite of many current IPO “growth “stocks  - then you know you will eventually have a “blue chip.”

-Francis Patrick Boland