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Blue chip stocks are shares of outstanding companies. Stocks of only a few high-quality companies can earn the tag of being a ‘blue chip’. This is the reason why the majority of investors flock to buy shares of these companies.
In this article, we will learn about those parameters which make a company a “blue chip”. These are those parameters that I’ve figured out myself. How? By looking at their numbers and comparing them with other companies.
Though it may sound simple, but observing so many companies was not easy. Hence we developed a stock screener which helps us to identify blue chip stocks.
It is also important to mention that identifying blue chip stocks is only like step number one. More important is to know if these stocks are trading at right price (to buy) or not? How to do it? We have another tool call stock analysis worksheet which can do price valuation calculations.
Warning! – Handle Blue Chip Stocks With Care
There are two main limitations of blue chip stocks.
- First: Their future growth prospects may not be as fast as other quality stocks. Reason? These companies has already become so big within their own sector that their future growth possibility is low.
- Second: Considering that blue chip stocks attracts so much attention, they often trade in overbought space. Hence, it is very difficult to find a blue chip stock trading at undervalued price levels. Read more here.
Hence, if you want to invest in blue chip stocks, it is mandatory to double check these two parameters before investing in them.
Considering blue chips companies what they are, they surely have the competitive moat above their rivals. So a slow but reasonable future growth is something which they can deliver.
But buy-price is something which investors need to control themselves. No matter how good is the company, buying its stocks at overvalued price levels can be as bad as buying bad stock. So, I personally give lot of emphasis on price at which I’ll buy a blue chip stock. What I do? I try to estimate its intrinsic value.
Present Situation is Unique
What is the present situation? I checked the SENSEX, and as on today (7th Sep’20), it is back to the 4th-Mar’20 levels. But this is not what makes the situation unique. Let me give you another metric:
Here is a list of few very large companies in terms of their market capitalisation. Out of them, some may be blue chip and some not. But for a moment, let’s forget about blue chips. We will first understand a crucial point about the present situation. This will help us to see blue chip stocks in a right perspective.
Though Sensex is back to 4-Mar’20 levels, but stocks of few large companies are still trading at good discounts to their 52 Week high price levels. So this brings us to this important question – shall be buy stocks of these very large market cap companies?
Simple answer is, if these companies fall under the tag of “blue chips” then we might consider buying them. But for sure further fundamental analysis will be done on them.
Here we will not discuss about fundamental analysis. For that you can check this link. Here we will focus on the topic of blue chip stocks only.
Blue Chips are Expensive Stocks
Generally speaking, blue chip stocks are most expensive stocks of the market. How we can say that? By looking at their P/E multiples. Again, allow me to present the numbers for few stocks which ranks high in their market capitalisation. Among this list some are may be blue chips and some not.
Generally speaking, ‘price to earning ratio’ (P/E) of stocks of large companies are very high. What does this mean? It means, they are trading at a price point which may be making them overvalued. Read: About low P/E stocks.
Pros and Cons of Blue Chip Stocks
One thing is for sure, most of the time, blue chip stocks trade at very high P/E multiple. So, if these stocks are so expensive, is it worth buying them? Yes and No.
- Yes: because they represent high quality companies. Target of any stock investor is to buy stocks of quality companies. Blue chip’s happens to be those easy-to-find quality companies. But as all are aware of their ‘quality’ attribute, everyone wants to buy them. They are always in demand, hence trades at high P/E multiples. Read more: Advantages of blue chip stocks.
- No: Because they may yield minimal returns if bought at current price levels. Why minimal returns? Because at current price levels they are already overvalued. Read: About high return stocks. Read more: Disadvantages of blue chip stocks.
Am I confusing you about blue chip stocks? Sorry, it was necessary to highlight the negative aspect of blue chip stocks (tendency to remain at overvalued price levels). Now, allow me to jump to the positive aspects of blue chip stocks…
How To Invest In Blue Chip Stocks?
Till now what we have seen is the good and bad points about blue chip stocks. Now we will use this information to devise a method to invest in these stocks. This will be a simple two step process:
- Screen Stocks: This is a very important step. It is here that majority people make a mistake. If one can pick the right stock from the plethora of average stocks, half the battle is won. I’ve personally suffered a lot and picked wrong stocks. Why? The process was simple, but I was not applying it correctly. Probably I was making it too complicated. The correct solution was much simpler. Check here for my blue chip stock screener.
- Check Price: Checking price valuation is key. In this article we will not discuss a lot about price valuation. But you can check my EXCEL based tool. It is primarily designed to estimate intrinsic value (fair price) of stocks. I generally use my blue chip screener and pick a good blue chip stock. Then I use my EXCEL based tool to check its price valuation.
Before we see my blue chip stock screener, let’s know a more about ‘what qualities makes a stock blue chip’. This understanding will help you to use our stock screener with a right perspective.
Quality of Blue Chip Stocks
You will find several definitions of blue chip stocks in the internet. But what I follow is simple and easy to apply for investing. For me blue chip stocks represent two unique qualities:
- Sector Leaders: What I mean by market leaders? We can select a sector leader in two ways. First by means of market cap and second by means of revenue. I prefer picking revenue over market capitalisation. We have developed at stock screener which can list down all stocks in a particular sector indicating their revenue.
- Profitable Business: How we can quantify a business as profitable? The most effective metric that we can use is Return on Asset (ROA). But we have taken it a level up. We see ROA (Return on Asset) and ROE (Return on Equity) in unison. It gives a more detail insight about the profitability of a business.
Blue Chip Stock Screener
We have developed a unique stock screener of our own. It is one of the easiest screeners around which one can use to find blue chip stocks. Allow me to explain how to use the screener:
- Step #1: Go to the screener page. You will find a drop down menu saying “Select a Screener”. Click on the drop down menu and select an option named as “Top Blue Chip Stocks”.
- Step #2: Once you select the “Top Blue Chip Stocks” option from the drop down menu, you will see two more sub-screeners. Use these sub-screeners to screen further. First, select the sub-screener named as “Select Sector”.
Step #3: After you have done the sector selection as explained above, you will start to see the industries operating within that sector. This will be visible in sub-screener 2. The next step will be to select an ‘industry’ of your choice.
- Step #4: In this step you will see a list of stocks operating within your selected sector and the industry. These stocks are listed in descending order in terms of their “revenue”. Companies with highest revenue in their sector-industry will come first. To identify a blue chip stock, check their ROA and ROE numbers.
Generally, top 3 to 5 stocks in the above list will qualify for the blue chip tag. But I’ll suggest you to look deeper into the following parameters. High numbers in each of these parameters is a clear indicator of being a blue chip:
- #1. Market Cap: High market cap is a first indicator that the company’s stocks are in high demand in the market. Check if the market cap of stock is within the top 5 in its industry.
- #2. Revenue: A further deeper insight can be obtained by seeing the revenue data. Higher revenue means the company has more business share in its industry. Again, check if the revenue is within the top 5 in its industry.
- #3. F-Score: Best F-Score is 9. Look for companies which has F-Score is 6 or higher. The higher is the F-Score more financially strong is the company. Please note that if a particular sector is going through a tough time, F-Score of almost all companies will be low.
- #4. ROA and ROE: As my rule of thumb, I would like to see a company whose ROA and ROE numbers are in double digits. Though, higher are these numbers the better. I first look at the high ROE, and then check if its ROA is in double digits. Moreover, it is always better to look at 5 years average ROA and ROE.
To save our time, we have developed a stock screener which provides all these metrics in one glance. Please go ahead and try our screener. It is intuitive and you will like it for sure.
Price Valuation of Blue Chip Stocks
After you’ve identified your blue chip stocks from the stock screener, you must take one more very important step. This is, checking their price valuation. How to do it? Easy way to do is through running financial ratios check.
But a better alternative is to try calculating the intrinsic value of the stocks. If you are not comfortable with estimating the intrinsic value, you can use my EXCEL based tool. This tool will not only estimate intrinsic value but will also do the following:
- It will present you the 10 year financial result of the company as a snapshot. This makes it very easy to review the 10 years data.
- The tool will also generate key financial ratios. These ratios can be used to gauze profitability, liquidity, debt levels, and price valuation levels of the company.
- Tool can also rate the whole company for you in terms of its price valuation, quality of management, financial health and price valuation.
For me, these insights in totality gives a lot of feel about the company. It prepares me well before taking the final buy-sell decision.
Advantages of blue chip stocks
The returns generated by blue chip stocks in long term are more assured. How they are more assured? In three ways: (a) they can yield consistent dividends, (b) their earning growth is more certain, and (c) their stock price is more stable. Let’s know more about these 3 points:
- Consistent dividends: These are stocks which has high market share and are also very profitable. This way they makes huge profits. Such companies often share their profits with shareholders in form of dividends. Hence blue chip companies are often the best dividend payers of the market. Read more about dividend paying stocks.
- Predictable growth: Strong business fundamentals of blue chip stocks makes their future growth more predictabille. How? High market share, high profitability, and low debt, makes them like invincible. It is hard of competitors to beat them in their game. This gives the pricing power to blue chip stocks – leading to future growth. Read more about pricing power and why Buffett loves it.
- Price stability: of blue chip stocks in falling market is one of its biggest advantages. It does not mean that price of blue chip stocks does not fall when index is falling. Its price will also fall, but the fall will be slower and recovery will be faster. Read more about why stock price fluctuate so much.
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. Here are the disadvantages of blue chip stocks…
Disadvantages 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.
What is the lessons we can learn from these examples? Fundamentals of blue chip stocks cannot be taken for granted. Let’s look at few immediate disadvantages of blue chip stocks:
- Overvaluation: Buying blue chip stocks at any price will not do. It must be bought at reasonable price levels. How to know what is a reasonable price? By estimating its intrinsic value. Read about this tool which can estimate intrinsic value.
- Not Risk Free: 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. Read more about what caused the 2008 financial crisis.
- Slower Growth: 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. Hence, it is essential to estimate ones investment goal accurately. If objective is faster capital appreciation in long term, growth stocks are better.
Passive investing in blue Chip Stocks
This can be done by investing in them through Index ETF’s or through index funds. Why Index? Because blue chip stocks are its major constituents.
Major indices keep reviewing their constituent stocks 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. Read more about exchange traded funds (ETF).
There are no doubts that Blue Chip stocks are stock’s of highest quality available in the market. What gives them this high stature is their proven past record.
Their business are so sound that it has resulted them to be the market leaders for prolonged period of time. Moreover, they also enjoy a huge competitive advantage above their business rivals. This gives them the much needed economic moat.
If one desires to start investing in stock market, the best starting point will be “large cap stocks”. Even better will be to buy the “prime stocks” within the large cap stocks.
Which are these prime stocks? They are blue chip stocks. But it is also important to buy blue chip stocks at undervalued price levels.