When you have decided to visit a certain destination, you will usually pick a time of year when the weather is most favourable. Of course, the weather is unpredictable and you might end up with an unpleasantly hot day when you purposefully chose to travel during winter, for example. Nevertheless, you do consider the weather before you pick your travel dates.
When people invest in stocks, too, they try their best to pick the ones that are most likely to deliver favourable returns. Very much like the weather, the stock market is unpredictable. That’s exactly why so many investors like to invest in blue chip stocks.
Blue chip stocks are, by definition, large companies that present a comparatively reliable investment.
Well, that’s the dictionary definition.
So what are blue chip stocks for an investor?
The answer is similar, but profiles companies a little more solidly. Blue chip stocks are the stocks of companies who are usually market leaders in their domain – they are usually characterised by a high market capitalisation, a strong financial track record and good potential for growth. Having been in business for long, these companies have already established trust among investors and provide an assurance of steady earnings and guaranteed returns over time in the form of dividends. For example, HDFC Bank, Infosys, RIL, etc.
For obvious reasons, both institutional and retail investors like investing in blue chip stocks. Institutional investors refer to mutual fund houses and other enterprises that might invest in stocks, and retail investors are individuals, like you and me. Everyone wants to invest in stocks that display a greater potential to deliver substantial earnings.
That apart, blue chip stocks have such a large market share that even a minor percentage price movement in the stock of the company could move the entire market, and also significantly impact investor returns. For example, Tata Consultancy Services Ltd (TCS) opened trade on 8 July, 2021, at Rs 3,298. By 10:45am, the stock price had gone by Rs 125, but in percentage terms, that is only 4%.
This could raise several questions in the mind of today’s suave and thinking investor: If it were that simple, wouldn’t everyone be investing in blue chip stocks only? Why would any other stocks even exist on the market, if that were true?
The second question is easier to answer: it takes time for companies to grow to the point that they may be called blue chip. In the meanwhile, companies might need to raise capital for expansion and growth.
Now for the first question: if it were that simple, wouldn’t everyone invest in only blue chip stocks?
For one, different investors use different strategies for growth. Some might follow growth investing, some may pick value stocks, for example. Meantime, day traders couldn’t care less about a company’s true worth in a lot of cases because they sell their stock within a single trading day, profiting (or taking losses) from minor price changes throughout the day.
Secondly, there is no formal list of blue chip stocks on the market. Becoming a blue chip company is an evolving process, so investors need to figure out whether or not a company currently qualifies as blue chip or not.
We’re going to attempt to understand how to examine a stock in order to decide for yourself whether it is a blue chip stock or not.
Here are some selection criteria that you can keep in mind when investing in blue chip stocks:
Criteria to consider when investing in blue chip stocks
Blue chip stocks will typically display a large market capitalisation. Market capitalisation is determined by the number of “outstanding shares” or in simple terms, the total number of a company’s shares in the market.
Market cap = Share price x Total number of shares of a company
There is no rule per se, but investors can perhaps consider companies with a market cap of above Rs 20,000 crore as potentially blue chip stocks. For example, ITC Ltd is a blue chip company with market capitalisation of Rs 2.49 lakh crore. However, investors should avoid the mistake of focusing solely (or too heavily) on market cap as a filter for blue chip stocks.
Financial track record
Look at the company’s financials with a magnifying glass. You want to see consistent growth in revenue and earnings that exceed expenditure. The debt levels are mostly negligible or easily manageable.
For example, Hindustan Unilever Ltd (HUL) has consistently reported growth in revenue and net profit on the back of their rural reach and demand for their products that they have built over the years. The company reported consolidated March 2021 net sales at Rs 12,433 crore, and profit at Rs 2,190 crore.
You should be looking at balance sheets and P&L statements for a period of three to five years, or even further back, to get a good sense of the company’s historical track record. Additionally, you might want to observe how the company’s revenues stand in comparison with its peer group or comp set.
If a company is to be a leader in a certain sector, logically it would need to have a fairly large share of the market, if not the biggest market share. A blue chip company will usually be one of the top 3 companies – by market share – in its sector.
Even when investing in blue chip stocks – where the main draw is that growth is somewhat reliable – investors need to have a strategy in mind. Investors like Warren Buffet and his mentor Benjamin Graham, who have become famous for their success as stock market investors, recommend what they call value investing.
Value investing refers to evaluating a company’s potential based on its price-to-earnings ratio (P/E ratio). A company’s earnings are held against its stock price to identify whether a stock is undervalued or overvalued.
An example is HCL Technologies. As of 8 July, 2021, HCL Tech has a trailing twelve-month P/E of 23.78 while the sector average in the IT industry is 34.55. This indicates that HCL Tech is possibly undervalued and has the potential for growth. The lower the P/E, the better the prospect for value growth.
Blue chip stocks are obviously popular, or enjoy tremendous demand, which in turn pushes their prices upwards. It is possible that the stock price gets inflated to a point that cannot be justified by the company’s actual earnings. At some point, investors will realise this and the stock price will reduce to a more reasonable point on the graph. Investors want to avoid buying stocks at a point when their prices are overinflated, irrespective of how large the company is.
If a stock meets the other criteria for being a blue chip stock, investors can filter out those that are currently overvalued.
ROE and ROA
Return on Equity and Return on Assets allow you to evaluate a company against its peers.
ROE checks a company’s profitability as compared to its shareholder equity. ROA checks a company’s assets and liabilities – it evaluates whether a company is utilising its assets wisely.
Blue chip companies will usually display a higher ROE and ROA. As with most of the considerations in this list, you should observe these ratios with regards to the company in question for the past 5 years.
For example, Gujarat Gas that has a market cap of Rs 46,266 crore as of 8 July, 2021, has a 5 yr ROE of 28% and 3 yr ROE of 33%, one of the best in the industry.
Avoid using a single criteria for selecting Blue Chip stocks. Even if a company is a market leader, do dig deeper and use various ratios and tools to help you get a clear picture of it’s true potential.