Back in 1923, the term ‘blue chip’ was borrowed from poker and was proposed for stocks that were trading at 200$ or more per share. Just like blue chips represent the highest value in the game of poker, similarly blue chip stocks are valuable due to their low risk and high stability proposition.
Blue chip stocks are associated with companies with long history of stability and strong market performance. These stocks are usually less volatile i.e. see slow and steady growth and are lower risk investments. As a result, these usually also have a higher price tag.
Blue Chip Companies
Blue Chip companies offer great value and stability and have been doing so for a long period of time. All these things are great features of a dependable investment capable of repeated earnings and profits for their investors. The way these companies are structured and operated, they are made capable to overcome economic upheavals and successfully steer themselves out of downturn and volatility. It is this resilience that makes them favorable over other startups.
The stable nature of these companies attract risk averse investors looking for safety. Usually these are investors who are in their later years and therefore more conservative with their investments as their risk tolerance is lower. For these investors, blue chip companies and their stocks, make a great investment option especially if they also offer dividend payouts.
Having said that, blue chip companies and their stocks aren’t limited to conservative investors only. In fact, these stocks should be part of any diverse portfolio in order to lower risks and increase portfolio performance and health.
Spotting Blue Chip Companies
Length of operation is one of the vital tell-tales of blue chip companies. Most of these companies have a long history of steady growth and increasing returns. This makes it easy for investors to buy and sell these stocks. History of consistent dividend payout is also a good sign that the company is a blue chip stock. But what exactly are dividends?
Dividends
Dividends are usually a small distribution of the company’s profits to its shareholders. This is a means for a company to reward their investors for having faith in them and investing in them. Also, this incentivizes the investors to invest further in these companies. The longer the dividend payout history, the more a company solidifies its blue chip status. In fact, a company earns an ‘Dividend Aristocrat’ status if it pays and raises its dividend consistently for 25 years. This is a coveted title and a great sign of a company’s eliteness among other blue chip members.
Newer companies are usually in need of continuous cash infusions to fund their operation costs. Most of their profits are allocated to these costs as well as further R&D. This renders them incapable of paying out dividends to their investors. However, a more stable company that has been around longer has enough cash on hand to allocate some of their profits towards dividend payouts for their investors.
Market Capitalization
You must have heard the term market capitalization. What it means is what the company is valued at in the market. It’s simply calculated by taking the number of shares of the company that are in the stock market, and multiplying it by their current share price. For blue chip companies, this number is $5 billion or more. In most cases it’s over $10 billion.
Growth History
Blue chip stocks are associated with companies that have a track record of sustained growth. This means that these companies have sound fundamentals and that their success isn’t a mere flash in the pan but rather a more reliable path towards growth and potential.
Stock Market Index
Another sign that a share belongs to a blue chip company, is the fact that often these shares are part of large-cap index funds. Index funds are usually made up of shares that belong to a specific area of the stock market. These indexes identify and track the market leaders which in turn can be a sign of the economic performance, especially in that sector. Some of these major indexes are the Dow Jones, S&P 500 and Nasdaq.
Safety offered by Blue Chip Companies
Historically, blue chip companies have survived many economic downturns. This is precisely why they are considered to be safer options compared to their non blue chip counterparts. Companies like Coca-Cola, Microsoft, Google, Walmart, Visa etc come to mind when talking about these safe investments. However, this does not guarantee that blue chip companies never fail. Companies like Lehman Brothers, Enron and General Motors have all faced adversity and lost their blue chip status.
Benefits of Investing in Blue Chip Stocks
For investors, there are many benefits of investing in blue chip companies. First and foremost is the security aspect that we discussed earlier. Second is the reliability of dividend payments which can be a source of reliable passive income for dividend investors. These are great options for investors who have low risk tolerances and can’t fathom putting their money into volatile companies.
Disadvantages of Investing in Blue Chip Stocks
Though attractive options for investors for obvious reasons, there are also some downsides associated with these companies. One of these downsides is the slow rate of growth of these companies. Though this lowers the risk of instability for these companies in the long run, this also means that blue chip companies do not see the explosive growth that some of the more exciting companies often do. It is also important to note here that the term blue chip should not lead investors into believing that these companies are immune to failure. No company is failure proof and every investor should constantly monitor the companies that they have invested in to keep an eye on their performance.
In Summary
To recap, in order to be considered a blue chip stock, the company associated with the stock must have a long history of success, a high market cap, offer financial security by weathering economic storms and perhaps even dividend offerings to their investors. All these factors make these companies a viable and attractive option for all kinds of investors. But it’s the risk-averse and older investors who are looking for financial security. Since blue chip stocks have the reputation of saving their investors from potential risks and instability, these stocks should be featured in portfolios of investors who are willing to take risks in their investment strategy. This way they can hedge against some downturn.
For more information on how to assess and select stocks for investment consideration, check out this post here for more information.