Investing is a world filled with jargon. There’s simply so many inside jokes and industry buzzwords, that even experts find it hard to keep up. But some terms remain firmly fixed in the investment lexicon.
One of those is a term the finance world has borrowed from pocker – blue chips.
If you’ve ever considered investing in stocks, you’ve probably heard the term. Here’s what you need to know about it:
What does it mean?
The financial world has borrowed the term blue chip from poker. In poker, the blue chips are the ones with the most value. Similarly, blue chip stocks are the ones the market considers the most valuable.
These are stocks for companies that are recognized across the world, have amazing products, and brands that have become household names. Think Apple, Walmart, or even AT&T.
Consider this – if you walk out to the street and ask a random person if they know a certain company, the chances of them spotting a highly valuable company is relatively high.
Everyone knows Netflix is a big deal and Google makes a lot of money.
But blue chips go beyond size and recognition. To be a blue chip a stock also needs to be relatively safe. Stability is what defines the blue chip company.
These companies are at the top of their game, really reputed, and promise long-term stability. They form the bedrock of the economy.
Why Are They Important?
The reason blue chips are important can be summed up in one word – stability. Investors tend to assign a certain section of their portfolio to blue chips to stabilize their investments.
It’s like putting part of your eggs in a basket next to your bed. You know the chances of anything going wrong are minimized and you want maximum security for at least part of what you own.
How Do You Spot One?
There’s a lot that goes into being a blue chip stock. Just being famous and massive isn’t enough. To figure out if a certain stock is a blue chip you need to ask yourself a few of the following questions:
- Have I heard of the company?
A good test to see if a company is a blue chip is to see if you’ve ever come across the brand. Blue chip companies tend to make a massive splash in the market.
They have recognizable names, massive market capitalizations, and are probably one of the most profitable companies in the country. Start with the top ten brands that come to mind when you think of the biggest companies on the stock market.
- Have the earnings being growing?
Now that you have a list of large-cap companies that are well recognized, dig deeper to see if the company has been profitable for a number of years.
Consistent and stable earning power is a sure sign of a blue chip company. Look up their earnings for the past five or even ten years. If you notice an upward trend, you’re onto a winner.
- Do they pay a dividend?
Dividends are closely linked to earning power. Large, blue chip companies tend to generate a lot of cash and pay a chunk of it out to regular investors in the form of dividends.
If you notice a trend of growing and stable dividends, it’s probably from a blue chip stock. Coca Cola Co. is a great example. Not only has the company managed to hang onto market share and revenues over the past half century, but it has also managed to pay a growing dividend for 50 years running!
That’s an incredible run for any company. KO is perhaps the best example of a blue chip company that simply cannot be stopped.
- Is it part of a stable industry?
Another key factor that you might want to consider is the nature of the industry. Great companies can still perish if the economics of their particular industry starts to turn against them.
Take, for example, U.S. Leather. You may not have heard of the company but it was one of the first stocks to be included in the Dow Jones Industrial Index.
The company had control over the vast majority of American leather products between 1893 and 1952, but was the only company to have liquidated in the index. Cheaper foreign imports and rising labor prices put it out of business. Blue chips can perish, and you need to be careful while selecting the industry.
- What does the future hold?
Things change and when the tide turns you want to make sure you’ve been paying attention. Think about Yahoo in the early-2000’s. It was the biggest internet company in the world and had more traffic than all the other websites combined.
Now, the company isn’t even taken seriously as a tech firm. Now, the company has been sold to Verizon for less than $5 billion. Things change and there’s no reason to believe you can predict the future.
But you can keep an eye out for changing trends and disruption. Blue chips have enough of cash and dominance to weather most storms, but you can expect a gradual decline if the whole industry has turned against them.
However, some industries can never be truly disrupted. If you think about Coca Cola and general Mills, there’s no reason their products won’t sell in the same quantities in the future.
There’s no killer app that will convince people to stop drinking soft drinks or eating cereal. That sort of stability and long-term predictability define blue chip companies.
Of course, investing in blue chip stocks isn’t a bed of roses. That sort of stability comes with its own compromises. Blue chip stocks are not going to grow exceptionally well. That means you can’t expect them to deliver outstanding capital gains. You also can’t expect blue chip companies to be particularly exciting or innovative. If there’s a game changing new technology coming up there’s a better reason to expect it from a scrappy upstart than General Electric.
Blue chip stocks are a great addition to any portfolio. These are companies that have a proven track record and can promise a very rare sort of stability. Your portfolio can expand over the years with dividend reinvesting and compound interest. But don’t expect high-growth and exciting product innovations. These companies are a necessary part of a healthy portfolio.
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