Investing in Blue-Chip Stocks

Posted on Friday, December 21st, 2018 MarketBeat Staff

Summary - Blue-chip stocks are known for their quality and stability. Although there is no single definition, investors typically agree that a blue-chip stock has a market capitalization of over $5 billion dollars which puts the company in the category of large-cap stocks.

In addition to having rock-solid balance sheets and delivering quarterly earnings growth that typically meets analysts expectations, many blue-chip stocks are dividend aristocrats meaning that they have a history of paying a high dividend and they make total shareholder returns a priority in the form of rising dividends.

However, this stability comes at the expense of growth. While these stocks can be attractive to value investors they are not considered attractive stocks for investors looking for growth. They typically have a beta of around 1, which means that these stocks have a high correlation with the broader market. Many younger investors who have a higher risk tolerance may benefit more from mid-cap or small-cap companies that can offer higher growth potential. 

When looking for blue-chip stocks to buy, investors can choose individual stocks or they can take advantage of the benefits of blue-chip stocks as part of mutual funds or exchange-traded funds (ETF) that specialize in. This is a good way for investors to benefit from rising dividends without having to pick and choose individual stocks.

Introduction

When we hear the words “blue chip” we may think of something of the highest quality and value. In the game of poker, the blue chips always represent the highest dollar value. A blue-chip panel of experts is considered to consist of individuals of the highest knowledge and character to bring to a subject.

When it comes to investing, the term blue chip is used with regard to stocks that also show high quality and value. However, blue-chip stocks tend to defy easy definition. Fortunately, Wall Street does that for us by identifying stocks as blue chips on the world’s largest stock exchanges. These stocks share many measurable and intrinsic qualities that put them in this coveted club.

In this article, we’ll take a closer look at blue-chip stocks. In the process of doing so, we’ll define the reasons why investors seek them out including the reason blue chip stocks are known as great dividend-paying stocks which can greatly increase an investor’s total return.

What is a blue-chip stock?

Fundamental and technical analysts alike agree there is no statistical definition for a blue-chip stock. There are no specific financial metrics that automatically turn stock into a blue-chip stock, nor does a stock's intrinsic value suggest that it falls into the blue-chip category.

There are however some broad guidelines that seem to inform the inclusion of a blue-chip stock on one of the major stock exchanges.

  • They are large, stable companies – Some analysts use a $5 billion market cap as an indicator of a blue-chip company. While that is not an exact number, it speaks to the idea that a blue-chip stock is, by definition, a company that has a large, well-managed balance sheet. A blue-chip stock generally has low-cost access to capital.
  • They lead their respective industries – One attribute that blue-chip stocks share is leadership in their respective industries. They have a large market share and are usually in the top three with regard to market share in a particular sector. Blue-chip stocks frequently, but not always, have products that offer a competitive advantage.
  • They have a long track record of dependable earnings – Another attribute that sets blue-chip stocks apart from other stocks is repeatable results. These stocks are not “flashes in the pan”, they are stocks that have demonstrated their ability to thrive during robust economic times and the ability to weather difficult economic times and continue to grow.

Another attribute that blue-chip stocks possess is higher profit margins over their competitors. This is due to intrinsic qualities such as the strength of their branding and fundamental metrics that includes pricing power and economies of scale.

Blue-chip stocks are about value first

Blue-chip stocks are not, by definition, aggressive growth stocks, but that does not mean that they aren’t growth stocks. However, their value comes through their stability and their consistent performance. The value of these stocks is rooted in strong business fundamentals as well as a high intrinsic value. Many of these stocks have established, iconic brand names that are associated with them. While this does not guarantee future performance (we can all think of brands and companies that are no longer around), it does tend to show that these companies are resilient in both up and down markets.

Blue chip stocks do not move much in price

Blue-chip stocks are known for their stability. This doesn't mean that blue chip stocks don't grow. It simply means that these stocks tend to show less volatility than the broader market. They will typically have an attractive price-earnings ratio. This stability is one of the qualities that make these attractive stocks to buy particularly for buy-and-hold investors who are looking for value and growth. While these stocks may not show the aggressive growth of small-cap or mid-cap stocks, they offer a higher degree of certainty for investors who can count on these stocks to rise during good times, but perhaps not fall as dramatically when the stock market is down.

Blue chips have a strong dividend history

Most, but not all, blue-chip stocks have a history of paying a dividend. And many make dividend growth as a reward to their shareholders a primary goal. One of the reasons this is possible is because blue-chip companies typically have rock-solid balance sheets. While it doesn't mean these stocks will never decline in value it does mean that they have a proven track record of making shareholder equity a priority.

Ben Graham, author of The Intelligent Investor said that conservative investors should look for blue-chip stocks that have a 20-year history of returning dividends. Many blue chip stocks are considered dividend aristocrats. This exclusive club (as of August 2018, only 53 companies were dividend aristocrats) is composed of S&P 500 companies that have not only made a dividend payout a priority but have also increased their dividend yield for at least 25 consecutive years. By definition, dividend aristocrats are required to meet certain market cap and liquidity requirements. This means that while not every blue-chip stock is a dividend aristocrat. All dividend aristocrats fall into the category of blue-chip stocks. 

Investors who reinvest dividends have historically been rewarded with a higher total return. However, when the stocks are evaluated without the dividends reinvested, the total return of these stocks as a group does not necessarily outperform the market.

Disadvantages to blue-chip stocks

For most investors, blue-chip stocks are appealing investments. However, the stability and well-known brand names associated with these stocks can also limit the profit profits for younger investors for a few reasons:

  1. Blue-chip stocks do not generally beat the stock market – Almost by definition, blue-chip stocks drive the market averages. Many of these stocks will have a beta close to 1 which means that the performance of these stocks will track closely to the performance of the S&P 500 Index. When the index moves up, these stocks will track very closely. The same, however, is true when the stock market goes down. Younger investors with a longer investment horizon can typically weather the ups and downs that may be associated with small-cap and mid-cap stocks that bring higher volatility.
  2. They focus on rewarding shareholders more than investing in the business – Smaller companies tend to reinvest their profits back into their business in the form of share repurchases or taking on debt to encourage growth in their business which, in turn, helps to lift their share price. Blue-chip stocks, by contrast, tend to invest their profits into dividends to reward shareholders. For investors who are not in need of the residual income that comes from these dividends, they may be better served to go with more aggressive stocks in an effort to build wealth.
  3. Blue-chip stocks are comprised of older, established companies. One of the qualities of blue-chip stocks is their intrinsic value. Investors of all ages recognize many of these names. However, younger investors are becoming early adopters and are in tune with the technological advancements that are creating many of the products that are changing our lives. These products are being developed by younger companies who may present more enticing growth opportunities.
  4. Good news is priced into blue-chip stocks. While blue-chip stocks are known for their stability, they are not without risk. This is because of the halo effect these stocks receive. Their stability creates a "benefit of the doubt" that is typically baked into the stock's price. When these stocks are the focus of bad news (e.g. a product recall, a poor earnings report, an executive scandal), the stock can be punished. And while younger investors, in general, have a higher risk tolerance than investors who are at or nearing retirement age, they may be better served to invest in stocks that have the ability to rebound from losses faster.

How to invest in blue-chip stocks

Investors looking for blue-chip stocks to buy can find them on every major U.S. stock exchange: the Dow Jones Industrial Average, the Standard & Poors (S&P) 500, and the NASDAQ. The NASDAQ, in particular, showcases the FANG stocks (Facebook, Amazon, Netflix and Google/Alphabet) that are drawing a lot of attention. Investors can find international blue-chip stocks on foreign indexes such as the TSX-60 index (Canada) and the FTSE index in the United Kingdom. Investors should perform the same due diligence with blue-chip stocks as they would with any investment. No investment is without risk, but blue-chip stocks do tend to be less volatile than other stocks, which can be more attractive to investors with lower risk tolerance.

Investing in blue-chip stocks offer several important benefits:

  1. Well-known brands. Legendary investor Warren Buffett has always advised investors to invest in companies who have businesses they understand. Investors who like Coca-Cola or are diehard Microsoft users may find there is security in investing in companies that they can “follow” without diving into balance sheets or other technical metrics.
  2. Ease of access. Because of their popularity, blue-chip stocks can be easy to buy and sell. This helps ensure that investors will be able to buy or sell a stock when they desire.
  3. Tax-free benefits. A blue-chip stock can be included in a stocks and shares ISA, which can protect gains from taxation.
  4. Many blue-chip companies offer diversification. Because of the size of these companies, many blue-chip stocks can offer investors exposure to different sectors in one stock. For example, an investment in a company like British Petroleum can give investors exposure to not only the oil and gas sector but also the commodities market because of some of its other business units.
  5. Investors have a variety of investment options. Blue-chip stocks can be invested in as part of an index fund or an exchange-traded fund (ETF). These funds can allow investors to invest in particular sectors (e.g. financial, technology).

The final word on blue-chip stocks

There is no single definition of what a blue-chip stock is, but they share common attributes that include strong balance sheets which include large, positive cash flows, enduring business models that create fundamental and intrinsic value which, in return, help these stocks to deliver solid growth. These are just some of the reasons that these stocks are considered to be secure investments. Investors who own blue-chip stocks rely on them for their consistent growth and also for their ability to provide regular dividend payments.

Some of the attributes that make blue-chip stocks can make these investments too conservative for younger investors who have higher risk tolerance and a longer time horizon that can make smaller stocks of cutting-edge companies more attractive.

Blue chip stocks deserve a place in every investor's portfolio. However, like any investment, they should not be the only stocks, particularly for younger investors who generally have a higher risk tolerance. For these investors, a path to wealth may include small-cap and mid-cap stocks. A balanced portfolio should also be sure to include investments in bonds and cash. Of course, the extent to which a portfolio should be divided among stocks, bonds, and cash will be different for every investor.

 

 

 

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