What Is a Blue Chip?
A blue chip is a nationally recognized, well-established, and financially sound company. Blue chips generally sell high-quality, widely accepted products and services. Blue-chip companies are 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.
- A blue chip refers to an established, stable, and well-recognized corporation.
- Blue-chip stocks are seen as relatively safer investments, with a proven track record of success and stable growth.
- Blue-chip stocks are still nonetheless subject to volatility and failure, such as with the collapse of Lehman Brothers or the impact of the financial crisis on General Motors.
Understanding Blue Chips
The term "blue chip" was first used to describe high-priced stocks in 1923 when Oliver Gingold, an employee at Dow Jones, observed certain stocks trading at $200 or more per share. Poker players bet in blue, white, and red chips with the blue chips having more value than both red and white chips. Today, blue-chip stocks don’t necessarily refer to stocks with a high price tag, but more accurately to stocks of high-quality companies that have withstood the test of time.
A blue-chip stock is generally a component of the most reputable market indexes or averages, such as the Dow Jones Industrial Average, the Standard & Poor's (S&P) 500 and the Nasdaq-100 in the United States, the TSX-60 in Canada, or the FTSE Index in the United Kingdom. How big a company needs to be to qualify for blue-chip status is open to debate. A generally accepted benchmark is a market capitalization of $5 billion, although market or sector leaders can be companies of all sizes.
A blue-chip company is a multinational firm that has been in operation for a number of years. Think companies like Coca-Cola, Disney, PepsiCo, Walmart, General Electric, IBM, and McDonald’s, which are dominant leaders in their respective industries. Blue-chip companies have built a reputable brand over the years and the fact that they have survived multiple downturns in the economy makes them stable companies to have in a portfolio.
The name "blue chip" came about from the game of poker in which the blue chips have the highest value.
Many Conservative investors with a low risk profile or nearing retirement may usually go for blue-chip stocks. These stocks are great for capital preservation and their consistent dividend payments not only provide income, but also protect the portfolio against inflation. In his book The Intelligent Investor, Benjamin Graham points out that conservative investors should look for companies that have consistently paid dividends for 20 years or more.
Blue Chip Stock Characteristics
Blue-chip stocks are seen as less volatile investments than owning shares in companies without blue-chip status because blue chips have an institutional status in the economy. The stocks are highly liquid since they are frequently traded in the market by individual and institutional investors alike. Therefore, investors who need cash on a whim can confidently create a sell order for their stock knowing that there will always be a buyer on the other end of the transaction.
Blue-chip companies are also characterized as having little to no debt, large market capitalization, stable debt-to-equity ratio, and high return on equity (ROE) and return on assets (ROA). The solid balance sheet fundamentals coupled with high liquidity have earned all blue-chip stocks the investment-grade bond ratings. While dividend payments are not absolutely necessary for a stock to be considered a blue chip, most blue chips have long records of paying stable or rising dividends.
An investor can track the performance of blue-chip stocks through a blue-chip index, which can also be used as an indicator of industry or economy performance. Most publicly traded blue-chip stocks are included in the Dow Jones Industrial Average (DJIA), one of the most popular blue-chip indices. Although changes made to the DJIA index are rare, an investor tracking blue chips should always monitor the DJIA to stay up to date with any changes made.
Blue-Chip Stocks' Safety
While a blue-chip company may have survived several challenges and market cycles, leading to it being perceived as a safe investment, this may not always be the case. The bankruptcies of General Motors and Lehman Brothers, as well as a number of leading European banks during the global recession of 2008, is proof that even the best companies may struggle during periods of extreme stress.
While blue-chip stocks are appropriate for use as core holdings within a larger portfolio, they generally shouldn't be the entire portfolio. A diversified portfolio usually contains some allocation to bonds and cash. Within a portfolio's allocation to stocks, an investor should consider owning mid-caps and small-caps as well.
Younger investors can generally tolerate the risk that comes from having a greater percentage of their portfolios in stocks, including blue chips, while older investors may choose to focus more on capital preservation through larger investments in bonds and cash.