When headwinds rage, blue chip stocks stand strong

When markets are a mess, investors look for strength and resilience. And in the world of finance, blue chip companies offer that. 

It's a term often bandied about, but what actually gives a stock blue chip status?

With its roots in high-stakes gambling, the term blue-chip is commonly used to refer to some of the highest quality listed companies. In the game of poker, plastic tokens (chips) are used by casinos to minimise the security hazard (and logistical difficulty) of having real cash piled on gaming tables. Typically, in order of lowest to highest, players trade cash for a combination of white, red, green, and blue chips.

In the following wire, we cover some of the most important characteristics of blue-chip stocks, which goes beyond simply finding the biggest companies by market capitalisation.

Key characteristics of blue-chip stocks

"You wouldn't call a company that's only been around a few years a blue-chip company," says Paul Taylor, Fidelity's head of investments for Australia.

“I don’t think a blue chip needs strong growth, but it should be profitable, stable and be a cornerstone of a market.”

The Lindy Effect

A theoretical phenomenon, this relates to the future life expectancy of some non-perishable thing such as an idea or technology, as referenced in Nassim Nicholas Taleb’s book, Antifragile: Things that gain from disorder.

“The longer something has been around, the longer it’s going to continue to be around – that’s the correlation,” Taylor says.
“If something has been around for 100 years, there’s obviously something about it that’s going to make it last.”

Taylor also emphasises that such companies tend to have survived through various market cycles and have been “tried and tested in different conditions.”

“They’re rock-solid businesses, I look at them as being foundational elements of a portfolio,” he says.

Taylor uses the analogy of high-quality direct property assets, which always maintain their value because of attributes such as their location.

He also looks to the mining industry as an example, where companies that are the lowest-cost producers and other attributes such as proximity to shipping ports or other logistics underpin their value.

"They’re the tier 1 assets everyone wants, and if you sell them, you're never going to get them back again," Taylor says.

Large market capitalisation 

In an investing context, the term “blue-chip” refers to large, highly profitable, mature companies. But adding stocks to your portfolio purely on the basis the companies satisfy these criteria doesn’t guarantee investing success.

As Hugh Dive recently told Livewire’s Ally Selby, “simply buying an ASX top 20 stock doesn’t mean safety.”

Looking at the ASX’s largest 20 companies, in terms of market capitalisation, over the last couple of decades, he noted many have not beaten the index. For example, AMP is down 90% and National Australia Bank and Lend Lease are both down between 10% and 15% over this period.

“I think only three or four companies in that top 20 from 20 years ago have actually outperformed the ASX. A lot of these companies are still around, but they are shadows of their former selves,” Dive said.

Though he conceded large companies tend to fare better during periods of extreme volatility, such as we’re seeing currently.

“They tend to work a bit better in that they have sympathetic bankers and equity holders that can raise money,” Dive said.

Sustainable competitive advantage

This refers to individual company assets, attributes or abilities that are difficult for others to even replicate, let alone exceed. This is an underpinning principle of Warren Buffett’s investment philosophy, who was among the first to apply the analogy of a moat to an investment context. Much like the defensive barriers widely used during the Medieval period that fortified castles or other buildings against invaders, competitive or economic moats enable companies to fend off competition and protect long-term profits and market share. In Buffett’s reckoning, companies can create such moats by building advantages via some of the following attributes 

Size – see the above discussion about market capitalisation.

Intangibles – something that can’t be measured via statistics alone, brand recognition is a key example of an intangible, alongside the intellectual property, government approvals, and company culture.

Costs – A company with a cost advantage can produce goods or services at a lower cost, which allows it to undercut competitors and/or achieve higher profitability.

Switching costs – You might have heard the word “sticky” used to describe companies or individual products or services. In this context, it means customers are likely to continue using them for an extended period of time. Switching costs are often a key reason for this “stickiness”. These costs are often psychological rather than financial in nature, including things such as time and physical (or mental) comfort.

Healthy earnings and profits

You won’t see any companies that have never turned a profit referred to as blue-chip stocks. Some of the world’s smartest and best investors – including GMO’s Jeremy Grantham – anticipated the Growth stock bubble would burst. And we’ve seen that happen – or something like it – since last September, when Value surged ahead of Growth for the first time in years. Non-profitable technology firms are over-represented among the stocks that have seen some of the biggest falls – as highlighted in the Goldman Sachs Non-Profitable Technology Index.

A focus on companies that are generating profit today is key in identifying blue-chip investments. As Schroders Australia's Joseph Koh wrote recently: “The quality of a business is ultimately reflected in its earnings.”

“It is one thing for a business to not report a profit and produce free cash flow because it chooses not to; it is another altogether if it has every incentive to do so and yet cannot,” Koh says.

Growth tailwinds

These can either be company- or industry-specific. Company-specific advantages might be some of the intangibles mentioned earlier in the discussion of competitive advantage. Examples of Industry-specific tailwinds include businesses leveraged to healthcare, specifically for the elderly, in the context of ageing population trends in many developed nations globally.

Quality cyclical stocks often have structural growth drivers that outweigh the cyclicality over the medium to long-term, writes WILSONS' Rob Crookston. “The current market turbulence may represent a good opportunity to buy a quality cyclical at a reasonable price after they have experienced a tough period in the broader sell-off,” he says.

Able to fund their own growth

Sage Capital’s Kelli Meagher says a critical attribute of Quality stocks – or indeed, blue chips – is that the company is “largely in control of its own destiny and not singularly reliant on external forces such as the economic cycle to prosper and grow.”

She suggests this leads to some sectors having a higher proliferation of Quality stocks – such as healthcare and technology.

Demonstrated ability to consistently pay dividends

This is often considered the most crucial attribute of blue-chip companies. A focus on dividend-paying stocks on its own is not a sound basis for portfolio construction, but it’s a key part of the process. In the US, the S&P 500 Dividend Aristocrats index is a collection of 65 stocks that have consistently increased their cash distributions for at least 25 years consecutively. Household names such as Procter & Gamble, 3M, and Coca-Cola are some of the notable inclusions on this list. The list has a 20% weighting to industrials alongside double-digit percentage exposures to consumer staples, materials, financials, and healthcare.

There are no Australian companies satisfying the same criteria, but several come close, with long track records of maintaining or increasing their dividends over long time periods.

Todd Hoare of Crestone Wealth Management suggests dividends may be more important in Australia than in the US. This is because our imputation system means dividends comprise a higher proportion of overall total returns.

10 Australian blue chips

CSL Limited (ASX: CSL)

Washington H Soul Pattinson (ASX: SOL)

APA Group (ASX: APA)

BHP Group (ASX: BHP)

Rio Tinto (ASX: RIO)

Fortescue Metals (ASX: FMG)

Mineral Resources (ASX: MIN)

James Hardie (ASX: JHX)

Newcrest (ASX: NCM)

Aristocrat Leisure (ASX: ALL)

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