You’ve probably heard the term thrown around a lot. Investors talk about “keeping their cash save,” in high quality “blue chip,” stocks. These exotic stocks are meant to be the creamy layer of the stock market. The sort of stocks everyone suggests and nearly everyone holds. But what exactly is a blue chip?
There isn’t really an official set of blue chip stocks. Rather, the term is loosely applied to companies that are massive and widely considered to be really stable, financially sound, and industry leaders in their respective market. If you can associate a company with high quality and incredible size, you’ve discovered a blue chip.
The term comes from poker, where blue chips are usually the highest valued chips on the table. But unlike the chips, there’s no sure way to tell if your stock is a blue chip or not. It’s a matter of collective perspective. If enough people know the stock and think it deserves to be a blue chip, it probably is. Here are some of the key signs you’ve stumbled on a blue chip stock:
- Market capitalization
To be considered a blue chip, the company needs to be extremely large. The largest companies are more likely to be tightly linked to the economy and less likely to fail suddenly. Although sudden bankruptcies and failures of large-cap stocks are not unheard of (Enron and Lehman Brothers being best examples), they’re extremely rare. Instead, the biggest companies in the country tend to do just fine. They sail along smoothly while the economy gets volatile.
If you wanted a technical criteria – a blue chip stock would have to be included in the top half of the S&P 500. Since the median market capitalization of the S&P 500 is $13 billion, a stock needs to be worth at least that much to be considered a blue chip.
- Financial stability
Simply being big is not enough. Investors need to feel secure purchasing blue chip stocks, so financial strength plays an important role as well. The company needs to have low debt, relatively low capital expenditure requirements, and high profit margins.
- Low beta
Another key aspect of blue chips is the lower volatility. A low beta stock moves around less than the market. This makes it a safer bet since risk of loss is reduced.
- Low growth
Low risk also means low rewards. You can’t really expect a blue chip stock to double in a short period of time (although they sometimes do). Apple’s market capitalization doubled in just three years after Tim Cook took over, but that sort of performance is the exception rather than the rule. For blue chips, the law of large numbers makes it difficult to grow double digit percentage points every year.
- Stable earnings
Stability is just as important as financial strength and low betas. A company in a very volatile industry will be unable to sustain profits and cash flows for very long. A rapidly shifting economy will change the fortunes of certain sectors. But stable earners will be able to reward shareholders regardless.
- Brand recognition
Another lesser known quality of a blue chip is the brand recognition. Nearly everyone knows Apple, Google, Coca Cola, and Walmart. The problem is not all blue chips have household names. While Johnson & Johnson is a household name, Berkshire Hathaway or Pfizer may only be known in certain circles. But the better known a company is the higher the chances of it being a blue chip.
- Market Leader
This feature of blue chips ties into brand recognition. A blue chip is usually a market leader in their sector. If you think about the biggest bank, biggest tech company, biggest oil producer, and biggest retailer, you probably know what a blue chip looks like.
- Cash rich or dividend paying
Finally, a blue chip is defined by the value it creates for shareholders. Financially strong companies need to generate high revenues and high profits, but that’s meaningless if shareholders don’t see the value accumulate in the form of cash. The best blue chips produce tremendous cash flows and usually pay a high dividend.
These are the eight features that usually define blue chips. You don’t need to focus on them exclusively, since the list of genuine blue chip companies is rather short. Instead, try to include at least one blue chip firm in your collection to offer a steady base for your wealth. Including a blue chip can help you create a rock solid dividend portfolio.