Blue chip stocks are shares in large corporations which are well-established and generally considered financially secure. If you’re confused by some of the language used to describe stock markets, you’re certainly not alone.
New investors can often be discouraged by the amount of jargon used in the industry. The sad thing is that the use of this unnecessary jargon leads some would-be investors to throw in the towel and pay some high-priced expert to handle their money for them. You could even make the argument that some of the jargon exists for exactly that reason!
But please don’t be one of those people who give up on understanding their own investments. Beyond all the seemingly complicated terminology and processes is a world of opportunity.
Most notably, the chance to take control over your own financial future.
‘Blue chip’ is one of the most widely used terms in the share market. Below we’ll explain what blue chip stocks are, some of the reasons you may want them in your portfolio, as well as some of the caveats.
Please keep in mind that the information below doesn’t take your personal circumstances into account and shouldn’t be considered recommendations. Our editors will regularly recommend shares in our premium publications, sometimes including blue chips, but the information in this article is purely educational.
What is a blue chip company?
Blue chip shares refer to companies at the top of their sector and have operated successfully for many years. They’re best identified by a market capitalisation in the billions.
The reason for the name ‘blue chip’ is because in the game of Poker the blue chip denotes the highest value.
The name came about in the 1920s when an employee at Dow Jones observed certain stocks trading at $200 or more per share. Today, blue chip does not necessarily refer to stocks with a high price tag, but is a name given to stocks of high-quality companies.
Blue chip stocks generally sell high-quality, widely accepted products and services. They are companies known to weather downturns and operate profitably in the face of adverse economic conditions, which helps to contribute to their long record of stable and reliable growth.
Blue chip classified companies are often household names. Their size and dominant positions give them a reliability that small-cap and mid-cap stocks do not have (small-cap and mid-cap refer to the size of a company’s value on the share market, or capitalisation; large companies like blue chips are often also called ‘large-cap’).
The strengths of blue chip stocks
Due to blue chips’ sheer size, they are the most owned shares in the market. They are attractive because their ongoing success is highly likely.
Blue chip shares can be tempting to own as they often pay out most of their profits to their shareholders in the form of dividends. Their already large size and strong position in their industry can often mean they don’t need or want to spend those profits on growth. That means you may not be looking at much in the way of capital growth on your investment. But if you’re happy to hold a share long-term for income, blue chips may be your first choice.
And if the company is growing and increasing profits as well, then the potential for investors is even stronger.
One of the best reasons to invest in blue chip stocks is that they generally are not affected by minor market disruptions or downfalls, or even major shifts in the economy. Consider Wesfarmers Ltd [ASX:WES], for example. This is a well-diversified blue chip company with a reputation of solid business management. Despite the recent market crash caused by the global outbreak of the coronavirus, Wesfarmers was able to take the economic downturn in its stride. That’s because even though some of it is businesses were badly effected — Kmart and Target, for example — its other business units like Bunnings and Officeworks saw a boost in trade.
Wesfarmers businesses are also considered to be of high quality with serious longevity. One reason for this is their brand recognition — they have become household names. Take Bunnings as an example. If you want to do a little home improvement or spend time fixing up the garden, Bunnings immediately springs to mind.
These businesses may also have a dominate market share. For example, it is difficult to think of a nation-wide office supplies retailer other than Officeworks — we’re not sure that there is one. That means they face very little competition in their operations and profits are unlikely to be stolen by competitors.
Factors such as these are what investors find attractive in a stock and what makes these companies successful. Keep in mind that this is not an exhaustive list. There are certainly many other factors that contribute to a blue chip company’s success.
Basically, the crux of the matter is that blue chip stocks are considered by some as the warm safety net investors look to, to pick up ‘easy’ profits, and improve their long-term portfolios.
Downside of Investing in blue chip stocks
While generally considered a safe investment, blue chip stocks do carry some caveats you should be aware of.
For instance, despite their reliability, they are not the most profitable group of stocks on the market. A massive corporation like Wesfarmers is not going to double in value in a few short months. In fact, holding Wesfarmers for a period of five years, from 2013 to 2018, would have returned a gain of about 16.5%.
Certainly not a bad investment given you wouldn’t receive that kind of return on your cash had you left it in the bank. Oh, and not to mention you would have received dividends during that time too.
More often, the biggest gains come from small-cap stocks. These are the smaller companies on the stock market. They tend to be much younger companies at the beginning of their growth stage. They also come with vastly more risk than in blue chip shares, but also vastly more potential for growth and profits. The dream, of course, is to buy into a speculative small-cap shortly before it launches into its growth journey towards becoming a blue chip stock, and a household name.
Moreover, just because blue chips are often the biggest companies — with cash in the bank and a dominant position over their competitors — it doesn’t mean they can never fail. Major economic crises can smash the value of whole sectors, and even the biggest companies aren’t immune. Nor are they immune from changing times, consumer patterns, technology, or simple mismanagement. Never assume that any investment, no matter how stable, is ‘safe’.
Think of companies like Blockbuster or Kodak. These were once dominant names at the top of their respective sectors. But changing market conditions and a failure to innovate and adapt saw them fail.
In fact, since 1955 to 2019, about 90% of Fortune 500 companies (which are considered blue chip stocks) are now gone.
That’s not to say they just disappeared overnight. Rather, we’ve provided this fact to give a little more context about the nature of blue chips and, more broadly, the stock market.
Nevertheless, investing in blue chip stocks can be a good strategy for new investors to enter the market.
Blue chip stocks — like Wesfarmers or the Commonwealth Bank of Australia — are usually the most insulated from major economic shifts and volatile markets. Meaning they can be some of the safest investments you can make. Noting the caveat that they do not generate the same returns as small-cap stocks.
Like everything in life, there are trade-offs we must make. But the pros of blue chip stocks certainly outweigh the cons. That’s what makes them such popular stocks to invest in and the reason that these companies have grown so large. However, they are not completely immune to the risks that are associated with investing and should be approached with the same level of research and caution you would apply to any investment.