What are the blue chips of the future?

Blue chip is synonymous with quality and dividends in the mind of the Australian investor, but are the companies considered as the blue chips of today likely to remain as the blue chips of tomorrow?

The ability to generate a consistent dividend stream has been a mainstay of those companies we deem blue chip but in the wake of COVID-19 related dividend cuts, does the Australian view of blue chip need to evolve?

We discussed the future of blue-chip investing with Peter Green, Head of Listed Products for Lonsec Research and James Gerrish, Portfolio Manager for Shaw and Partners and author of investment newsletter, Market Matters.

Defining a blue chip investment

“Blue chips have been in the past large size, industry leaders, well run and in the Australian context, very much also looking at dividends and fully franked dividends. So, we’re talking companies like the big four banks, Telstra,” says Mr Green.

The top 20 companies listed on the S&P/ASX 200 have often been treated as a default blue chip index and this provides an interesting demonstration on the evolution of blue chip investing.

Only 20 years ago, the top 10 constituents of the S&P/ASX 200 were filled with banks, telecommunications and even news media, with Telstra topping the list (1). While the list of today is still heavily dominated by banks, there’s a few we might not a have predicted in the past such as Australian biotech leader CSL Ltd or supermarket companies like Woolworths or Wesfarmers.

Mr Gerrish finds it interesting that CSL Ltd has joined the definition of blue chip.

“It’s moved the needle from thinking about dividends underpinning blue chips to more towards stocks that are delivering really strong absolute returns. So blue chip to me is something that’s reliable, generally large, robust, a leader in their industry,” 

Both see this movement towards a view on absolute return as a trend for the future.

“Increasingly blue chip is being equated with a quality style. A quality style looks at things like ROE growth, EPS growth, large investment in intellectual property and also low leverage,” says Mr Green.

Dividends and blue chips

COVID-19 may be driving the trend towards viewing blue chip investing as about absolute return in Australia. Investors have had to start to reconsider their understanding of blue chip investing and their strategies in the wake of many companies, including traditional blue chip investments in the form of the big banks, cutting their dividends.

In this instance, we may be starting to move towards the way the US or Europe view blue chip investing.

Mr Gerrish says, “The S&P 500 back in the early 1900s (2) had a dividend payout rate of about 90%. Every 90 cents in every dollar was paid out as dividends to investors. Now the S&P 500 has a dividend payout rate probably around 30%. So, the bulk of those earnings are being reinvested into future growth, and that's why you see those growth orientated companies sort of rise to the top overseas the way the market's set up. And that's probably one of the reasons why it's been outperforming a bit over Australia at a rate of one and a half times.”

By contrast, he notes that the Australian market has dividend payout ratios of around 75%, slightly skewed in the current environment but overall a traditionally high ratio.

Mr Gerrish sees the focus on dividends as having hampered the growth of companies in Australia.

“Afterpay for instance in 2016 had a market cap of about $165 million and are an $11.5 billion dollar company now. Telstra at that same time was around a $60 billion company and it’s now a $34 billion company. They invested in growth dividends along the way but examples like that start to change investment mentality,”.

That’s not to say that we’ll see the current blue chips disappear.

“There’s always going to be a role for the big four banks and Telstras in portfolios. I think people are increasingly aware of the total return of investing but this is more of a focus on capital growth than income returns. Over time, that sort of earnings growth will lead to dividend growth as well,” says Mr Green.

Turning to Asian blue chips

Mr Green notes that the composition of Asian markets has seen the rise of different blue chips compared to Australia.

“Asia certainly is showing strong growth in the tech sector but also we’ve seen in Asia, you’ve got the rise of the middle class there. So, when you look at the financials and consumer discretionary sectors there, they are a large part of those indices and they have much greater EPS growth trajectory compared to the Australian context, just because of those demographic factors that are driving those stocks and earnings,” he says.

Consumers have embraced technology across Asia, with blue chip companies like Alibaba and Baidu a prime example of this.

Both Mr Green and Mr Gerrish find including international blue chips is an important way of diversifying their clients’ portfolios, particularly given the dominance of financials in Australian blue chips compared to internationally. They’ve used direct investments or ETFs depending on client needs. An example of an ETF focused on Asian blue chip investing is the ETFS Reliance India Nifty 50 ETF (ASX:NDIA) which invests in the 50 largest and most liquid Indian domiciled companies.

The future of blue chip investing

Mr Green views the future of blue chip investing as linked to some of the rising global themes.

“I think the market is really taking a good, hard look at things such as we’ve just seen with COVID-19, all of a sudden, we’re working online and this happened quite seamlessly. The whole idea of the digital economy is a very interesting area. We spoke about Asia before and the rising middle class and also what they’re calling the fourth industrial revolution, the automation, the AI, the machine learning,” he says.

Some of companies following the trends might not be blue chips now but could be down the track, such as Afterpay. Mr Gerrish notes payment platforms have huge potential.

“We’ve got the incumbents, these being Visa, Mastercard which are really dominant over in the US, but I think there’s other kinds of payment platforms that are interesting… You need to wait to see what companies get to that point of reliability of earnings before they become a blue chip,” he says.

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Sources:

1. https://www.spindices.com/documents/education/education-marking-20-years-of-the-sp-asx-index-series.pdf
2. While the S&P 500 began in 1957, the S&P Weekly Index has been used as a substitute for earlier years.