How to bake a blue chip

Investing in “blue chips” – large, highly profitable, and mature companies – has long been a popular strategy for investors. But contrary to its popularity, research has shown (i) that the largest stocks consistently underperform over the long-term. Perhaps investors have fallen victim to survivorship bias?

Rather than looking at the big stocks themselves, we recently asked some Livewire contributors for their view on which ASX ex-50 stocks could be a future blue chip (and conversely, which blue chip could lose this status). To expand on this idea, we asked those contributors what to look for in a potential future blue chip.

Responses come from Ben Chan, Evans and Partners; Ben McGarry, Totus Capital; and Daniel Moore, Investors Mutual.

First mover advantage is no longer enough

Ben Chan, Evans & Partners

In searching for a stock that could become a true blue-chip stalwart, we look for a product or service with a clear competitive advantage that not only removes the barrier to entry, but also has reasonable line of sight over medium-term disruption risk and is internationally scalable. These are all key identifiers for a potential addition to your portfolio. 

It’s important to note, though, is that in today’s environment, where trends and ideas are readily replicated given increased global information flow, first mover advantage (while certainly a supportive element) is not enough to sustain a long-term leading position in a rational industry. There are numerous examples of well-run companies that have been unable to extract appropriate returns due to a poor industry structure. However, if a company has a strong enough product offering as initially described here, then it follows that it may not necessarily be at the mercy of an overly competitive industry structure. 

It is also important to consider a stock that has an offering that could be scaled internationally, as the Australian market itself is most likely not large enough.

Avoid aggressive accounting practices

Ben McGarry, Totus Capital

There are four key attributes we look for in potential future blue chips:

1. An industry or company specific tailwind for growth. This could be as simple as population growth and market share opportunity for a retail company or more people transacting online for an internet company.
2. High quality earnings. By this we mean recurring earnings that are presented to the market in a conservative way. We avoid companies that resort to aggressive accounting practices such as excessive capitalisation of costs or overly optimistic assumptions as this can be an indication that management is having to peddle hard to maintain a level of growth or a valuation multiple that the market has ascribed to the business.
3. We like businesses that can fund their own growth without excessive reliance on external equity or debt capital. Equity and Credit markets can and do freeze up from time to time and the consequences in terms of dilution can be severe for equity owners whose company is forced into raising capital at the wrong time.
4. Owner operator culture. We like management teams that are aligned with shareholders through significant equity investments in the business. In our experience this tends to promote disciplined behaviour and a culture of seeking optimal outcomes with a focus on the long term.

It's all about the long term

Daniel Moore, Investors Mutual 

In looking for companies with the potential to be blue chips, you need to establish these attributes:

1. A strong and enduring competitive advantage
2. Recurring, not cyclical earnings
3. A capable management team
4. The ability to grow over time.

You can't just get excited about short-term growth. If growth is driven by a theme or a fad, without a strong competitive advantage, it may not be long-lasting and might attract competitors. For example, in the ‘Buy Now, Pay Later’ segment we’re seeing a lot of excitement about Afterpay and Zip, which is inviting competition that may impact the long-term prospects of these companies. Similarly, even a dominant player like Netflix, showing strong growth, is seeing several competitors enter the space including Disney and Apple.

Recurring earnings are also important for a blue-chip company. When companies’ earnings are more cyclical, they may have very strong earnings growth in the growth phase of the cycle. However, when the cycle changes and the economic growth falters, such companies might not look so attractive.

Footnote:

(i) Arnott, Rob, and Lillian Wu. 2012. “The Winner’s Curse,” Journal of Indexes (October 29).

More from this series:

• The blue-chips of the future

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