What are blue chip stocks?
Blue chip stocks, of course, line the lists of the Dow Jones Industrial Average and S&P 500. We are talking about companies like Coca Cola, and often companies with high dividend yields.
Blue chips – large caps and dividend yields
Many investors look to solid dividend payments as a way to boost retirement income and contribute to an attractive total return.
Typically, blue chip status is conferred on stocks with a large market capitalization, meaning the total of all stock trading in the market adds up to a lot – typically ten billion or more, sometimes a lot more. So the “large cap” just means a high market cap. These are often considered safer and more conservative stocks to buy.
Blue chip stocks often have good long term track records, and are often counted among respected analysts’ stock picks. Often, they sport impressive long-term track records, but not always.
Value investing – do the math
There’s an old expression among real estate investors, that “you make your profit when you buy it.” This means you must be careful not to overpay if you want to make a decent return on rents and when you eventually sell the property. The same sort of logic applies to stocks. Let’s look at an example using a rental house with simplified math.
Say if you buy the rental for $100,000, and clear $1,000 a month after expenses and vacancy. That’s $12,000 on $100,000 or 12% a year, pretty good. But if you paid $1,000,000, the return drops to $12,000/$1,000,000 or 1.2%, which is pretty poor. Plus, the odds of selling for a higher price are much better if you got a good deal and only paid $100,000, than if you overpaid and sunk $1,000,000 into it.
Many analysts believe – like Warren Buffett – that stocks should be scrutinized the same way. It’s not just about the high quality or sexiness of the real estate or the stock.
Stock investors as business owner
It’s really about looking at the stock as a piece of a business on which you expect to make a decent return. Too many people view stocks like lottery tickets, and don’t spend enough time thinking about the accounting numbers to see if the price you will pay for a piece of the business is justified by the underlying value of the business operations and assets, and by the expected earning capacity of the business.
So from this value perspective, you may want to consider only blue chip stocks that are selling for what seem like reasonable prices in order to have a good shot at making money over the long term.
Price to earnings ratio
Things like the price to earnings ratio – the price of the stock now divided by the earnings per share, and the dividend yield – the expected payout to shareholders divided by the stock price – are pretty fundamental metrics.
With this valuation discipline in mind, you may consider that blue chip value stocks make sense as part of a diversified portfolio.