Blue Chips – beware of collecting them just because they are cheap

“Buy blue-chip stocks and collect dividends”.

You’ve probably heard that phrase at least a dozen times. Investing in blue-chip stocks has been a popular strategy among investors or retirees who want to invest in high-quality companies that pay a stable or growing dividend but don’t have the time to continuously monitor the market.

In this article, we try to breakdown whether buying beaten-down blue-chip stocks is a good strategy.

The term blue-chip originated from Poker, where the highest paying chip colour is blue.

Why buy blue-chip stocks?

Blue-chips are among the best or highest quality companies that an investor can own, but there is no one definition of defining what company is a blue-chip company and what isn’t.

Among many factors, blue-chip companies have strong earnings quality over many years, have growing dividend payout to shareholders, enjoy high returns on capital and have a robust balance sheet and cash flows that can sustain its operations.

Essentially, you can consider them high-quality businesses with a strong track record that produce long-lasting value for their owners.

Because these high-quality companies tend to have built a resilient and proven business over time, they are well-regarded by their owners and are depended upon to produce dividends which can be reinvested to produce higher levels of incomes in the future.

For example, some of the biggest blue-chip stocks in the world are stocks like AT&T, ExxonMobil, Nestle and Procter & Gamble.

The problem with blue-chips

The reasons for owning blue-chips as described above are pretty clear… right?

Except, when it isn’t.

With rapid technological and societal change, the nature of businesses has fundamentally evolved faster than ever before. Blue-chip companies tend to be larger and less agile than new entrants or startups, making them a vulnerable target for disruption.

If we take a look at our local Singapore businesses, for example, there are several stocks once considered to be blue-chips such as SPH, Singtel and Singapore Airlines.

However, if you take a look at how their businesses are getting disrupted in today’s information age, where digital media, digital telcos (MVNOs) and budget airlines have also competed for a slice of the pie, it is difficult to predict how much longer these companies can survive.

Taking SPH as an example, SPH’s operating margin has almost halved since 5 years ago and its dividends have fallen almost symmetrically. You can see how the share price has also trended, from S$4.15 to S$1.88 today.

SPH’s operating margin, 2015-2019. Source: 2019 Annual Report
SPH’s dividend per share, 2015-2019. Source: 2019 Annual Report
SPH share price, 2015-2020. The dividend yield is roughly 5.85% today, but is it sustainable?

SPH is just one of the many local blue-chip companies that have seen falling profitability and margin erosion. There are others that might seem to be more resilient to technological change, such as our local banks DBS, OCBC and UOB.

But they too might be impacted by other longer-term factors that might potentially erode their future dividends – persistent low-interest rates, rising regulatory compliance costs, and lost market share to new players (e.g. digital banks, fintechs).

Even some of the global blue-chips such as Coca-Cola have seen many years of sustained dividends, but there is always a possibility of profitability impact in the future – for example, if consumers reduced their sweet drinks consumption due to health awareness, then there will be a clear impact on Coca Cola’s profitability.

Blue-chip stocks are still risky

It is crucial that while investing in blue-chips has lower risk characteristics than smaller, growth-oriented companies – they are still risky investments.

They are still vulnerable to the risks of the market, in addition to any corporate risks associated with the company itself (e.g. profitability, liquidity, governance etc).

A general decline in market conditions can also lead to a sell-off in blue-chip stocks, and you are still vulnerable to paper losses. A sustained decline in economic outlook can also pose further risks such as credit defaults, especially for companies that are highly cyclical in nature (e.g. banks, tourism) or have high fixed costs (e.g. manufacturing, airlines).

How to invest in blue-chips

I personally think that investing in blue-chips has to be selective.

I like to find those that are less cyclical in nature with healthy margins, participating in a growing trend (e.g. technology, e-commerce, online payments) who are in market-leading positions (e.g. top 3 by market share).

The best time to accumulate these high-quality blue-chip stocks is during a recession or market correction when everyone is selling indiscriminately and fearful of investing.

A relevant question to ask yourself is whether this company is something you’d buy again if the price drops by half.

As the saying goes, be greedy when others are fearful.

Disclaimer: Content is provided for information only, and no liability will be accepted for any direct indirect or consequential losses or damages arising from or in connection with the use or reliance of this article’s contents.

Derrick is a digital native, finance geek and avid photographer. He loves spontaneity but is a control freak at the same time.

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