What are blue chip stocks? Why they are called that? Which stocks are blue chips?
These are first few queries that comes in our mind when we talk about “blue chip stocks”, right? So let’s answer them quickly before getting into the details.
What are blue chip stocks? These are high quality stocks of big, established, renowned companies listed in stock market since decades.
What are blue chip stocks named after? They derive their name from the “coloured Chips” used in the game of poker. The poker game played at homes has a toy-set with three colours:
- White Chips (valued as $1).
- Red Chips (valued as $5).
- Blue Chips (valued as $10).
“Blue chips” are the most valued chips. This analogy has been used to also identify the “most valued stocks” trading in stock market.
Which stocks listed in Indian stock market are blue chips? We will answer this question at the end. But before that let’s get some basics right about the blue chip stocks and its screening criteria.
At the end of this article, I will also share my idea of the “best way to invest in blue chip stocks“.
So lets start by asking the most basic question of all, which also keeps people guessing about its relevance…
#1. What are blue chip stocks?
There is no “one” attribute that makes a stock blue chip. In fact there are several factors in combination that can transform a stock into a blue chip stock.
Lets understand it like this, to become a great formula-1 driver only driver’s skill is not enough. A combination of technology, vehicle, driver’s skill, driver’s overall fitness, team-work, good race-track, luck, etc is necessary.
Similarly, for a stock to become a “blue chip” following ten (10) attributes contribute to its making:
- Largest Market Share.
- Operating at peak since many years.
- Large and established company.
- Highly valued.
- High product quality.
- Strong financial health.
- Strong Brand Name.
- Pays high dividends.
- Has high weightage in major stock indices.
- Quick-pick for mutual funds (big investors).
Generally speaking, all the above 10 attributes makes a stock fundamentally strong. Any stock which is fundamentally strong will pick the attention of the following:
- Large investors.
Whenever a “fundamentally strong” stock begins to start attracting so much “attention“, it means it is on its path to become the next blue chip.
Out of the above 10 attributes of blue chip stock, few of them are worth a further discussion.
#1.1 Largest Market Share…
Every company operates in a specific “sector”. Even the so called diversified sector companies like ITC, L&T etc, has their own core operating sector.
Like ITC is into hotel & tobacco business forming its core. L&T is more into construction business.
So when we say that blue chip companies has a large market share, it means it has a large market share within its sector. How to quantify “large market share”? By looking at the “sales turnover” of the company.
Let’s take an example of a sector in India (Automobile). In this sector, there are 90 stocks (including auto ancillaries). All these 90 companies, generated a sales turnover of approx. Rs.3.96 Lakh Crore in last FY’18.
The sector leaders of this sector are as below. Please see their market share indicated as “% of Total Sales”:
The top 3 stocks contributes more than 45%+ of the total sales for the sector (Rs.3,96,160 Crore).
Out of these 3 stocks, M&M may be a relatively new entrant, but Maruti and Tata Motors has been the market leaders of Automobile sector in India since at least last 2-3 decades.
These market leaders are all giants, and established companies in India. Their foothold has only been increasing in India. How we can say that? See the amount of money they are spending in R&D and product development.
When a company does this? When they know that, such investments are going to give returns in future. This a sign that these companies are becoming more sure of their stance in the Indian market.
Hence these 3 stocks can be easily tagged as a “blue chip”.
#1.2 Highly valued by the market…
Not all stocks are valued highly by the market. There are selected few stocks, which out-weights others.
But how to quantify if the stock is valued high or low by the market? Look at its market capitalisation.
What makes a stock become highly valued in the market? This point cannot be seen in isolation with the above point (high market share). In fact high market share is one of the major reason why a stock becomes highly valued.
But just because a company has a “high market share” cannot make it also “a most valued company”? There are other factors which must also contribute to make a stock most valued.
Let’s again take an example of Automobile sector to understand this point.
In terms of “Market Share”, Maruti, Tata Motors, and M&M were the main contenders of Blue Chip stocks.
But in terms of high market valuation (Market Cap), Tata Motors is ranked only 8th.
Other stocks which has pitched in between Maruti and M&M are Bajaj Auto, Eicher Motors, Hero, Bosch etc.
The point is, though Tata Motors has a bigger market share, but few smaller companies are “valued higher” by the market. Why?
This can be only when there are other factors working in favour of Bajaj, Eicher etc, right? What are those factors?
- Product quality.
- Financial health.
- Brand Name.
- High dividend payment.
- More weightage in indices.
- Better investment grade.
All these points are leading towards building a strong business fundamental for a company.
So what we have seen till now are, what are blue chip stocks and what makes a stock blue chip.
Now we will see, what are the benefits of investing in blue chip stocks?
#2. Benefits of blue chip stocks?
Blue chip stocks are perhaps the first choice of pro investors. Why? Because the returns generated by blue chip stocks in long term are more assured. How they are more assured? In two ways:
- They yield consistent dividends.
- Their future price growth is more certain.
- In difficult times, their stock price is more stable.
Consistent dividends makes blue chip stocks very likeable for investors interested in short term income generation. Coincidently most of the large investors like “consistent and high dividend yielding stocks“.
Future price growth predictability of blue chip stocks are high, because of their dominant position in the market. Their high market share and strong fundamentals gives them the pricing power (economic moat/ competitive advantage).
Price stability of blue chip stocks in falling market is one of its biggest benefits. It does not mean that price of blue chip stocks does not fall when index is falling. Its price will also fall, but there will be a difference. How?
- Price fall will be slower.
- Price recovery will be faster.
But is it not that everything about blue chip stocks are sounding too good to be true? Yes, I agree. If everything is so hunky-dory about blue chip stocks then why people investing in them have lost money in the past?
There is no doubt that blue chip stocks are the safest investment bets for long term investors. But blue chip stocks must also be dealt with some care. We cannot blindly invest in blue chip stocks. What are the control points?
We will see them when we talk about how to screen blue chip stocks. But to understand that, let’s see the limitations of investing in blue chip stocks first…
#3. Limitations of blue chip stocks?
Once a blue chip, always a blue chip.
This is a wrong assumption. No company can continue to enjoy its prime position forever.
Some known examples are: Reliance Communication, DLF, Kodak, Nokia, Lehman Brothers, etc. These companies once enjoyed almost monopoly business in India/world. They were the ones which enjoyed phenomenal economic moat. But today all them are almost dead (except for Nokia, DLF which is still breathing).
What is the lessons we can learn from these examples? There is a tendency among investors to take fundamentals of blue chip stocks for granted. This should not be done.
Occasional check of fundamentals of even blue chip stocks is a must.
#3.1 Blue chip stocks cannot be bought at any price.
People often assume that blue chip stocks will anyways yield good returns in long term. Hence buying them at any price will do.
As blue chip stocks represent the best underlying businesses of its sectors, hence they are always in demand. This is the reason why they mostly trade at overvalued price levels.
Catching a blue chip stock at undervalued price levels is tough.
This is one reason why, performing a price valuation of blue chip stocks before purchase is more important. Why?
Because even blue chip stocks, bought at overvalue price levels, may yield negative returns even in long term.
#3.2 Blue chip stock alone cannot provide diversification?
People often refer blue chip stocks as “risk free”. Why? Because they represent companies which are giants of their fields.
But what about those moments of time when the whole stock market is falling (like in 2008-09)? The price of blue chip stocks will remain stable? No they will also fall. How to protect ones portfolio from such value erosion? By diversification. How to do it?
By spreading ones money into several non-related investment options. What are these non-related investment options? Debt, gold, real estate, REITs, etc.
#3.3 Blue chip stocks does not grow as fast
In most cases this is true. As Blue chip companies are all matured, large companies, hence their future growth is not as fast.
If we will compare potential returns of a good “growth stocks” verses a blue chip stock, the latter cannot win. If one assumes the opposite and buys a blue chip stock, then it will be a misjudgement and may also lead to grave dissatisfaction.
Hence, it is essential to estimate ones investment goal accurately. If objective is faster capital appreciation in long term, growth stocks are better.
If objective is stable and assured returns in long term, blue chip stocks are better.
If one can safeguard oneself from the above limitation of blue chip socks, future success will become more plausible.
Now, let’s get to the topic which I think you like the most….
#4. How to screen blue chip stocks?
The first screening criteria for blue chip stocks is already explained in #1.1 and #1.2.
Whatever stocks are shortlisted by applying the above screener, must also be checked with respect to the below parameters.
#4.1 Strong Balance Sheet…
Blue chip stocks must have a strong balance sheet. What it means by a strong balance sheet? A strong balance sheet ensures that the financial position of the company is strong. How to know it? By using the below ratios:
- CA / CL > 1: (Current Asset / Current Liability).
- TA / TD > 4: (Total Asset / Total Debt).
- TE / TD > 2: (Total Equity / Total Debt).
#4.2 High Profitability…
Blue chip stocks enjoys a competitive advantage in the market. This ensures a relatively higher profitability for blue chip stocks.
How to identify a highly profitable stock? One must look into the companies financial reports.
One of the best indicator of high profitability is RoCE (Return on Capital Employed). My rule of thumb is, RoCE above 30% indicates good profitability.
#4.3 High Dividend payouts…
Dividend distribution is a problem for companies whose fundamentals are not strong. Hence a company which can distribute dividends even in bad times, becomes special. Such special companies are tagged as “blue chips”.
“Consistent dividend payouts” is a vital indicator of blue chip shares. Why? Because it shows how confident the company is about their future net cash flows.
Future net cash flow means:
- Assured cash-inflow (in form of account receivables).
- Assured cash-outflow (in form of account payables).
For a company to stay alive, these two (2) form of cash flows must continue to happen. Though it may sound simple, but it requires best business strategies to ensure a “balanced net cash flow”.
Very less company can claim to be “net cash flow confident” year after year. And the companies which are so, deserves the tag of “Blue Chip”.
No company will pay dividend by compromising their current liquidity needs. So a company which consistently pays dividends, is a big indicator of their “strong cash flow position”.
Moreover, it also helps to keep the shareholders happy in short term.
#4.4 Investment grade credit rating
This is one of the safer ways to identify a blue chip stock. How we can do it in India? CRISIL is a credit rating agency in India which provides credit rating of Indian companies.
The easiest way to do it is to visit CRISIL’s website, search for your company’s name and get the rating.
Though rating of all companies may not be available here, but ratings of all major Indian companies (which we call as blue chips) can be found.
Rating provided by CRISIL are indicated below.
All “AAA” rated companies represent lowest credit risk companies. It is widely accepted that AAA rated companies can be tagged as a “blue chip”.
#5. The best way to invest in blue chip stocks?
Investing in individual stocks is my personal favourite. But it comes with its own share of risks. Yes, even blue chip stocks are risky. How? Because not all stock will continue to be a blue chip all its life.
This is a type of risk which is associated with all stocks. But with blue chip stocks the probability of occurrence is less predictable. Why? Because no body expects a “current blue chip stock” to go broke in coming years. But this is a fact that it happens and it is unavoidable.
Suppose you have invested in one such blue chip company. In next 10 years time, the company behaves normally and gave you decent capital appreciation. But post 10th year, the rating of that company begins to fall.
If you can catch this falling trend in the beginning its good. But if not, then your invested money is in a major risk. Why? Because when credit rating of blue chip stocks are downgraded, there is a severe impact on its market price.
How to avoid such occurrences? Two ways:
- Keep oneself always aligned with the business fundamentals of your holding stocks, or
- Invest in blue chip stocks via a major index.
Investing in blue chip stocks via index. How?
Why Index? Because major indices keep reviewing their constituent stocks very immaculately. Stocks which no longer deserves to be a part of the index will be replaced with a better one.
Stocks which are losing their position in the index are the ones which are losing their blue chip status.
When investing is done via an index, individual investor need not worry about checking business fundamentals of their holding stocks. Major indices like Sensex, Nifty etc will necessary be composed of only blue chip stocks. Stock which does not deserve to be there, will be automatically removed.
How to invest in blue chip via indices? Buy the index via ETF (Exchange Traded Funds).
Whenever you have some extra fund, buy an index ETF.
To know more about exchange traded funds (ETF) check this article.
#6. List of Blue Chip Stocks in India 2018
I generally use the S&P BSE Dividend Stability Index to quickly find a list of my blue chip stocks. Why I follow this list?
Because this list provides a list of those stocks which has done the following for its investors over a period of last 7-9 years:
- Provided stable dividends, or
- Provided increasing dividend.
Further, S&P BSE Dividend Stability Index includes only large cap stocks in its list. This further strengthens the reliability factor of this index.
Top 5 Best Performing stocks from this index is presented below:
- H3YR = High absolute Returns in Last 3 Years (%).
- HMCap = High Market Cap (Rs.Crore).
- HDY = High Dividend Yield (%).
- LB = Low Beta.
Have a happy investing.