You are in a game of poker and playing for the big bucks. You take a look at your hand and you see a 7, 8, 9, 10 and a jack all in hearts. A straight flush. You are almost certain you have the winning hand which is why you raise with your most valuable chips. The blue chips. The only player left in the game ‘calls’. Your opponent has a flush, you end up having the best hand and get all chips on the table. Now let’s bridge this game of poker to finance.
When a firm is of substantial size, generates stable revenue and is (often) the leading firm in the industry, it is considered a ‘blue chip’. The market value of such a firm is usually over a billion dollars and because this firm is generating very stable revenue, the stock usually performs similarly to the stock market as a whole. In the US, this trend is roughly equal to the S&P 500 which is an index consisting of the 500 highest valued firms in the States. Therefore, not coincidentally, all these firms can be considered blue chips and they generally behave equally on the stock market. Some examples of blue-chip firms are: Apple, IBM, Disney, Microsoft and I bet you can name a dozen more yourself. For which types of investors are these low-risk firms interesting then? Ones who are simply looking for a stable growth on their portfolio, which in today’s world quickly outpaces the interest received on savings. If you possess a dividend paying blue-chip stock, also called a dividend growth stock, the dividend payments alone usually correct for inflation each period. What are other benefits? And what are the counter arguments associated with having a portfolio solely consisting of blue-chip stocks?
Let’s first look at the benefits. Previously, I stated that the dividend growth stocks usually correct for the inflation rate. Usually this is around the 2% benchmark but in these Corona times, inflation rates differ. Even though, the stable returns caused by dividends and steadily increasing value on these stocks are a definite pro. Besides that, there are significant tax-benefits associated with buying and holding blue-chip stocks. In some cases, even after the owner is deceased, the benefits continue. Moreover, risk-averse investors prefer a diversified portfolio in order to decrease risk (even more). More often than not, the blue-chip companies have subsidiaries all over the world. Meaning that you can attain a globally diversified portfolio without investing your euros in non-EU based concerns. This global diversification decreases risk while the performance of a firm is not solely based on one subsidiary and one currency. If, for instance, due to the insanely high percentage of debt to GDP ratio in Japan (237,1% ;0) the Yen takes a dive, resulting in lower returns from the local subsidiary. Luckily, the blue-chip firm possesses globally diversified subsidiaries who don’t trade with the Yen. Consequently, the stock price is relatively unaffected. The last benefit I will mention is the high liquidity associated with this stock. If an investor needs cash, they can create a sell-order for this stock, knowing there will always be a buyer. Namely, the blue-chip stocks are very frequently traded among both institutional and individual investors.
In the end, if the dividends are reinvested, the blue-chip stocks tend to have an expected return between 8 and 12%. Generally, the longer the stock is part of your portfolio, the higher the expected return.
You cannot invest without knowing both sides of the story. Therefore, here are some disadvantages associated with holding blue-chip stocks. First of all, returns are not all cats in the cradle. There is significant risk associated with investing in a well-known company. For one thing, this risk lies in analysts tracking the company’s every move. Therefore, bad news about the company is quickly brought to the public, resulting in a stagnated stock price. Speculators therefore have no business in this type of stock. They are not interested in blue-chip stocks while these short-term investors are looking for a quick bug. Because stock prices of blue-chip firms are generally not expected to be volatile, buy low/sell high desires are usually unanswered. Another disadvantage might be counterintuitive. You would initially expect these large firms, who are often leaders in their industry, to yield high returns. This is more often than not untrue while their success means less room for growth and resulting in moderate returns.
To conclude, let us take a look at the two types of investors, active and passive. An active investor who, for instance, invests in a startup that releases the latest tech-gizmos, focusses more on growth stock. These startups reinvest their gains rather than distributing their returns as dividends to their shareholders. This results in less dividends, but a steeper, positive trend on the stock chart. For whom would a portfolio consisting largely of blue-chip stocks in the end be attractive then? For the passive investor. The investor who desires low risk and steady growth on his/her portfolio. The steady old reliable blue-chippers won’t give you the jackpot, but at the same time they won’t let you down in the long run.