What are Blue Chip Stocks? Why Should you Invest in Them?
Blue chip stocks are nationally reputed, large and financially sound companies. These are companies with a long history with quality products or services and have the ability to maintain leadership or substantial market share in their respective industries. Blue chips are also known to be resistant to economic downturns, challenges and other forces and manage to provide steady growth even in tough market conditions.
Origin of the Term Blue Chip
The term ‘blue chip’ is derived from a game called ‘poker’, where there are different betting discs (or chips) which are white, red and blue in colour. Each chip has a different value – for example a white chip is worth $1, a red is usually worth $5, and a blue $10. Blue chips are higher in value.
Pros and Cons of Investing in Blue Chip Stocks
There are different views on blue chips and experts highlight its advantages as well as drawbacks. Although I’m more convinced with the advantages than the drawbacks, let me provide a neutral view here.
|Strong financial performance||Low returns|
|Potential for regular dividend||Poor dividend yield|
|Lower downside risk||Slow capital appreciation|
|Less volatile||Cannot beat the benchmark or index returns|
|Steady long term returns||Cannot be a multi-bagger (generally speaking)|
|Well regulated and governed||May be conservative in exploring new opportunities (however, this is debatable and varies case-to-case)|
If you observe the points above you find that most of the drawbacks are like counter arguments against the advantages (for ex. Lower downside risk vs. slow capital appreciation). These are not the only advantages or drawbacks, but these would have given you an idea of why investing gurus recommend or shun blue chips.
Why Should you Invest in Blue Chip Stocks?
The question is answered to an extend above where the advantages are evident, but let me give you a few more additional points or ‘Food for Thought’ to tell you practically why blue chip stocks are better than their smaller peers such as mid caps, small caps, penny stocks, etc.
Access to a Diversified Business
Diversification of investments across different asset classes or sectors is important. Similarly, an investor should look at companies which have a diversified or broad based business model. Take the case of Hindustan Unilever, a diversified FMCG player – they are in to food and beverages, personal care/hygiene, cosmetics, etc.
On the other hand take the case of Tech Mahindra, an IT services company which is focussed on IT services for telecom industry – which is more focussed towards one sector within an industry. This does not necessarily mean that Tech Mahindra is a bad choice – its only an example to show the diversification aspect. Similarly there are companies which have local or regional presence, while blue chips have national presence.
If you closely observe the products that you purchase for your daily consumption, you will find several dozens of brands. For example there are shampoo brands such as Pantene (P&G), Clinic All Clear (HUL), Fiama Di Wills (ITC), etc. Same goes for noodle brands such as Maggie (Nestle), Top Ramen (Nissin Foods), Yippie Noodles (ITC), etc.
These are brands that are worth hundreds or thousands of crores and drive a lot of revenue and profits for the company. When you invest in blue chips you invest in these top selling brands which generate several crores worth of turnover every month. Some of the products sell at all times – irrespective of whether economy is good or bad.
Resilience to Economic Downturn
This point has been emphasized many times. But remember that only those blue chips which are in defensive sectors (pharma, FMCG, healthcare, etc.) might exhibit this feature.
Why is it so? These are the sectors which serve the basic consumption needs of the economy, which may not slowdown significantly even during crisis situations. For instance during the Lehman Brothers crisis in late 2008 most FMCG stocks (which went down initially) gradually started moving north against the market trend. Why? Because investors and analysts had more faith in the FMCG and pharma stocks, compared to other sectors.
Low Debt or Leverage
Leverage is the strategy of using more borrowed money to generate higher returns from business. Is it good? Yes provided the business returns are significantly higher than the cost of borrowing. If not the company will be paying a higher debt service than its income and erode its balance sheet.
In simple terms its like borrowing too much on your credit card, to discover that your credit card payments exceed your income. Although debt is necessary for any business, too much of debt can erode profits and make the company insolvent.
The beauty about blue chips is their strong capital base and balance sheet. Most of them don’t require debt given that they have strong promoters as well as strong reserves and cash flows to take care of their working capital and future needs.
In cases where they require debt, they are able to raise funds through debenture or bond issues or borrow from banks. Blue chips have the advantage of borrowing at lower cost compared to smaller or newer companies. Most banks/financial institutions are comfortable and are more willing to lend to blue chips.
Large corporations such as Enron and Satyam have seen one of the largest scams in history. However, these are quite less probable at large companies but cannot be ruled out. In some cases for instance LIC Housing Finance when there was a bribery scam, the issue spread and hit the stock to its lows, but later the stock recovered and gave good returns as proper systems and checks were established. Since most companies are well governed this is less likely and even if a problem were to occur it can be controlled and minimized before it impacts the whole organization.
Future Plans and Vision
Blue chips have a strong management team, who have a sound understanding of the business as well as the commitment to take the company forward to achieve its vision.
For example, Infosys has been a stalwart and role-model for most IT firms in India.
They also proved their management depth and capabilities because they had a fairly large management talent pool which enabled them to draw a succession plan starting from Narayana Moorthy to Nandan Nilekani to S.Gopalakrishnan to S.D.Shibulal.
You have to ask the following questions to understand how the company will pan out in future:
- How long will the company last?
- Will its products/services continue to sell? What will the company’s market share be – say 5 years or 10 years from now?
- What if the CEO or key personnel leave? Do they have a succession plan?
- Is the company’s business model diversified enough and flexible enough to tap new opportunities if existing business are threatened?
These are some of the questions that require further research and analysis, which you can do yourself if you follow the news or updates from the company regularly.
It is a given that blue chip stocks are highly shareholder friendly in different ways:-
- They pay regular dividends (higher dividends if business performance is excellent)
- They also declare bonus on achievement of certain milestones or special occasions (silver jubilee, success of a brand/project, etc.)
- They share their profits generously with shareholders, and at the same time keep some reserves for future capital needs. (unlike smaller companies they don’t have to compromise on dividends for the sake for growth capital)
We have seen a number of business/financial aspects, but these are not the only factors. There could be several areas like employee relations, compliance to regulations, being socially responsible, etc. Blue chip stocks are also known for their generous contribution to environmental, social and charitable activities and initiatives. This does not mean you should restrict yourself to blue chips only.
However, blue chip stocks are definitely a must for any portfolio. A portfolio can have mix of blue chip stocks and mid cap stocks, but when you are in a dilemma you must favor the blue chips because even if you go wrong you will still be safe.
Start your portfolio with a couple of leading blue chips before you get in to other stock picks. This will ensure that you don’t panic or rush to sell them. Blue chips are indispensable like family gold or silver, which can last for generations to come.