A blue chip stock is one that is well-established, financially sound, and historically secure. Blue chip companies are those that have a history of posting earnings and paying dividends, all while continuing to increase profits. While there will always be some fluctuation in markets, and all companies go though occasional downturns, blue chip companies are known for their strong executive management teams that make intelligent growth decisions, and for their high-quality products and services. Blue chip stocks, which are also known as large cap stocks (because the companies have a high market capitalization of $1 billion or more), tend to rise and fall in conjunction with the stock market in general.
Examples of blue chip stocks include Coca-Cola, Disney, Intel, and IBM. Because the return on blue chip stocks is close to a sure thing, the stocks tend to be very expensive and have a low dividend yield. These drawbacks are more than offset by the earnings and dividends paid. Most blue chip stocks are offered by companies that have been around for decades, or even longer, but new companies can break into the blue chip ranks if analysts expect the company to last.
A recent example of this phenomenon is Yahoo!, the World Wide Web search engine and directory. Yahoo! has been in existence for less than a decade, but in that time, it has positioned itself as perhaps the leading company on the Web. That stature, combined with its financial performance, have made Yahoo! a blue chip. The company's stock sells for more than $150 per share, it is one of the few Internet companies to show a profit, and its growth has been phenomenal. As reported in Fortune, Yahoo! grew 242 percent in size while its stock gained 517 percent in value in 1997. The following year, when it reported earnings of 13 cents a share after predicting a penny a share, the stock grew 584 percent. That is the kind of performance that pushes a new stock onto blue chip lists.
While some people still doubt the financial security of stocks, blue chips are the closest thing you can find to a sure thing on the stock market. In fact, a 1996 study by Jeremy Siegel reported in his book Stocks for the Long Run found that blue chip stocks are quite possibly the best financial investment a consumer can make. By analyzing financial data from 1802 to the present, Siegel reached the conclusion that blue chip stocks were a better investment than gold, bonds, or Treasury bills.
According to a report in Forbes, one dollar invested in stocks in 1802 would have been worth more than $350,000 in 1995. In comparison, one dollar in T-bills grew to only $261, which is only 0.0007 percent of the rate of return on stocks. Treasury bonds did not fare much better, finishing with $752, while gold did even worse, although figures were not available. Inflation and taxes hurt all of the investments, but it hurt bonds the worst. Not available until after World War II, bonds would have wiped out many an investor who chose them for their only investments. Accounting for inflation and taxes, Siegel found that $1 million invested in bonds immediately after the war would be worth only $218,000 in real purchasing power in 1995. The truth presented by the study is simple—blue chip stocks are the best investment vehicle for the long run. It should be noted that Siegel's study was completed before the stock market soared to record highs in 1998 and 1999, or results may have been even more one-sided in favor of stocks.
Financial advisor John Campbell of the firm Goldman Sachs reaffirmed Siegel's buy recommendation in 1998. At that time, Campbell maintained a list of 20 to 25 blue chip stocks that had returned 36.42 percent annually for the three years he managed the list, compared with a return of 30.2 percent for the Standard and Poor 500. Campbell's advice about buying blue chips, which he discussed in Fortune, was to "invest in the best businesses and the best managements, pay a fair price, and over the course of your life your stocks will do better than the market."
As with any stock, there are positives and negatives with blue chips. Because blue chips are the oldest and best-known companies, they are easy to follow, often ending up on the front page instead of just in the financial section of the local newspaper. It is easy for investors to track these companies and evaluate their advertising and marketing strategies for themselves. Finally, they are a great tool for teaching kids about the stock market by using brand names they recognize, like McDonald's or Walt Disney.
The negatives associated with blue chips are basically the same as for other stocks. Even blue chips can take a nosedive, as every company makes a mistake at some point in its history. And as the old saying goes, the bigger they are, the harder they fall. The more you have invested in a company, the worse its mistakes can be for your portfolio. In addition, blue chip stocks often have smaller dividends than even the 4 percent yield associated with income stocks. This puts off some investors.
Most blue chip stocks are traded on the New York Stock Exchange and make up a significant portion Dow Jones Industrial Average and the S & P 500 Index. They can be purchased through brokers or online. The best time to buy blue chip stocks is after a disappointing earnings report or after a particularly bad public relations blunder—the stock is sure to dip then, making it more likely that you will buy low and be able to sell high. If you divide the company's net assets by the number of shares it has outstanding, and the stock is selling for less than that number, consider buying because it is a very good value at that point. Also, try to avoid companies that have accrued a large amount of long-term debt.
"Do You Believe? How Yahoo! Became a Blue Chip: A Tale of How Wall Street and the Rest of Us Learned to Stop Worrying and Love an Insanely Valued Internet Stock." Fortune. June 7,1999.
Dreman, David. "A (Very) Simple Truth." Forbes. October 14,1996.
McLean, Bethany. "Investing Made Easy: Buy Great Companies." Fortune. March 16, 1998.
Morris, Kenneth M., Virginia B. Morris, and Alan M. Siegel. The Wall Street Journal Guide to Understanding Money & Investing. Fireside, 1999.
Siegel, Jeremy J., and Peter L. Bernstein. Stocks for the Long Run. McGraw-Hill Professional Publishing, 1998.
SEE ALSO: Fortune 500