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What are blue chip stocks and how do you trade or invest in them?


MongiIG

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A description of blue chip stocks, a rundown of the best examples and how to identify and distinguish them from other companies with large market capitalisations. Read on for comprehensive coverage.

chartSource: Bloomberg
 
 Charles Archer | Financial Writer, London

What are blue chip stocks?

Blue chip stocks are the shares of businesses that are highly reputable, financially stable and long-established in their sector. Over time, the companies considered to be blue chip tend to change – only 28 of the original FTSE 100 stocks listed in 1984 were still on the UK's premier index by 2017.

In simple terms, a company is considered to be blue chip if it's near the top of its sector, features on a recognised and high-volume index and has a well-known brand.

What does it take to be blue chip?

The exact requirements to be termed a blue chip are – unusually for the financial sector – vague. Opinions vary from investor to investor, but broadly speaking, the company needs to:

  • Be at or near the top of its sector
  • Feature on a recognised index (e.g. FTSE 100, S&P 500, ASX 200)
  • Be or own a recognised brand
  • Have a history of reliable growth and often consistent dividend payments

The term itself was allegedly coined by Dow Jones employee Oliver Gingold. After observing that certain stocks reliably traded above $200 per share, Gingold denoted them 'blue chips' after the most valuable chip colour in poker.¹

It's important to note that some blue chip companies can still be quite small in relative terms if they operate in a niche sector – with the distinction occasionally blurred between a blue chip and a medium cap.

The opposite end of the investing spectrum is a 'penny stock'. In the UK, these are typically regarded as companies trading for less than £1 per share and with a market capitalisation of under £100 million. Both of these conditions need to be met to be classified as a penny stock. While there can be some leeway if a company is slightly over the limit, this is a well-understood definition.

By contrast, 'blue chip' is not a standardised term. Whether you might classify a company as such requires an element of subjectivity.

Investing in blue chip stocks is a popular long-term strategy, but these shares are not risk-free.

Advantages of blue chip stocks

  • Blue chip stocks are usually viewed as low-risk because they tend to post stable earnings, often pay out dividends and have investible credit ratings²
  • Dividends combined with reliable capital returns make blue chip shares among the most reliable portfolio investments
  • They are also well-trusted by investors because they have large market capitalisation – the very opposite of penny stocks, which offer larger rewards but without dividend income, stability or low risk
  • There is little volatility to worry about, and therefore investing in blue chips requires less investor effort

Disadvantages of blue chip stocks

 

  • Blue chips are not immune to falls, crashes or even bankruptcy. When negative events happen, such as the 2008 global financial crisis or the 2020 pandemic crash, it can cause substantial damage as a large investor base sells off
  • These types of stocks don't experience the short-term price movements needed to generate short-term trading income
  • Blue chips are unlikely to generate the higher returns that can be made on riskier investments, such as start-up companies, as they have less room to grow
  • They are often in high demand, and therefore investors pay a premium for the lower risk and heritage name
  • Smaller rivals can eat up market share without careful management

Examples of blue chip stocks

The following does not constitute a formal or exhaustive list of blue chip stocks, but it is true that the largest companies within well-known indices – such as the FTSE 100, CAC 40 or DAX – are widely considered to hold prestige.

Again, whether a company remains a blue chip is subject to change over time. But some common names are:

  • Apple
  • American Express
  • AstraZeneca
  • BP
  • Coca-Cola
  • Diageo
  • Disney
  • General Electric
  • IBM
  • Johnson & Johnson
  • McDonald's
  • Microsoft
  • Nike
  • Pfizer
  • Unilever
  • Verizon
  • Wal-Mart

As you can see, most of these companies either are well-known brands or owners of some (for example, Unilever owns dozens of premium food brands). To some extent, whether a company holds blue chip status depends on the subjective viewpoint of the everyday layman, including its brand perception.

How to identify a blue chip stock

Classifying most blue chip stocks is typically not complex given their size, prestige and market-leading specifics, at least from a general perspective. These companies are at the pinnacle of the market and often have wide economic moats – it would be very difficult to supplant Apple or Coca-Cola, for instance. They are businesses that trade on exceptional brand loyalty.³

Identifying factors of blue chip stocks include:

  • Lower volatility than shares in companies without blue chip status due to their institutional profile and strong financial vigour
  • Very high liquidity, as they are frequently traded by both institutional and retail investors. This creates a self-fulfilling prophecy, as all can be confident there will be buyers for their shares
  • Usually little debt, high market capitalisation, a stable debt-to-equity ratio, a high return on equity and a high return on assets employed
  • Strong balance sheet fundamentals that lend blue chips investment-grade credit ratings
  • Usually long and stable history of dividend payments
  • Being on a blue chip index
  • Being a bellwether of the wider industry's performance

However, companies considered to be blue chip can change over time. For example, in the FTSE, only 11 of the original 30 prestigious Dow Jones stocks in 1987 remained on the index by 2017. Companies including Kodak, Sears and General Motors have exited the index – businesses that at one point would have been considered exceptionally safe investments. In addition, while losing blue chip status can be difficult, it's equally hard if not more so to attain it. Apple, the world's most valuable company since 2011, was not featured on the Dow until 2015.

Many confuse blue chip status with simply being very large, but the two things are not the same. A blue chip is almost always large, but large companies are not always blue chip. Consider the AMC Entertainment short squeeze, which catapulted the market cap of the company to many billions – few would have classified the business as low-risk at the time.

Whether blue chips can be considered a good investment is subjective. However, many investors consider allocating a significant portion of their portfolio to these types of large, well-capitalised companies. Often, investors may choose to buy shares in an index tracker which includes many of the most popular blue chips, such as the SDPR Dow Jones Industrial Average ETF Trust.

While blue chips are often viewed as safer than lower-level growth stocks or other risky investments, there is no such thing as 'safe' when it comes to investing. General Motors was forced to declare bankruptcy in 2009 after extensive commercial damage caused by the global financial crisis – this was once one of America's titans of industry.

Blue chip stocks summed up

  • Blue chip stocks are shares of businesses that are highly reputable, financially stable and long-established in their sector
  • Companies considered to be blue chip can change over time; for example, only 11 of the original 30 prestigious Dow Jones stocks in 1987 remained on the index by 2017
  • Blue chip stocks are usually viewed as low risk because they tend to post stable earnings, often pay out dividends and have investible credit ratings
  • These types of stocks don't experience the short-term price movements needed to generate short-term trading income
  • Long-term investors may choose to buy shares in an index tracker that includes many of the most popular blue chips, such as the SDPR Dow Jones Industrial Average ETF Trust

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