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With the long bull market run in technology stocks finally running out of steam, there’s been a shift in investor appetite from high growth to so-called ‘blue chip’ companies.
This has resulted in the predominantly blue chip FTSE 100 index recording a relatively modest fall of just 0.3% this year, compared to a drop of over 20% for the tech-heavy Nasdaq Composite index in the US.
Blue chip stocks often appeal to investors during an economic recession or a period of high inflation such as we have at the moment. They tend to operate in more defensive sectors such as energy, consumer staples and pharmaceuticals, which are more resilient to a downturn in consumer spending.
Ryan Lightfoot-Aminoff at financial advisory firm Chelsea FInancial Services says: “The market this year has swung profoundly to value [from growth] in the wake of higher inflation and increasing interest rates. This trend will continue as investors struggle to justify the lofty valuations of technology companies in a potential recession.”
Let’s take a closer look at investing in blue chip companies and the potential benefits and drawbacks for investors looking to diversify their portfolio.
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The phrase ‘blue chip’ is thought to have derived from poker, where the blue chips are the highest-value of the three colours. Blue chip companies are typically well-established and financially sound and usually possess some, or all, of the following characteristics:
As a general rule, blue chip stocks form part of the most prestigious stock market indices, such as the FTSE 100 in the UK and the Dow Jones, S&P 500 or Nasdaq 100 in the US.
The term ‘blue chip’ is also used to describe traditional US companies such as Verizon, Coca-Cola and Lockheed Martin which operate in the telecoms, drinks and defence sectors.
However, it’s more contentious as to whether technology giants such as Microsoft, Apple and Amazon qualify as blue chip given their presence in higher-growth, less mature markets and low (or no) dividend payments.
Mr Lightfoot-Aminoff comments: “As businesses become larger and more established, the focus on returning cash to shareholders often grows. Blue chips tend to be better dividend payers, being able to pay out more of the free cash flow they create.”
This contrasts with ‘growth’ companies, such as US technology stocks, which often reinvest surplus cash into the business to generate future growth.
A measure of income is ‘dividend yield’, which is calculated by dividing the (historic or forecast) dividend per share by the current share price.
According to trading platform IG, the average dividend yield of the FTSE 100 is currently 3.7%. In other words, investors should receive an annual return of almost 4% if they bought all of the FTSE 100 stocks at their current share prices.
Some UK blue chip companies are trading on higher dividend yields, particularly in the energy and commodities sector where booming prices have resulted in near-record profits.
Mining company Rio Tinto is currently trading on a historic dividend yield of 12%, which may appeal to investors looking for above-inflation returns.
Dividend policy is also used as a proxy for the financial health of a company, meaning that an unexpected dividend cut is often interpreted as a bad sign. For this reason, blue chip companies tend to have a consistent policy of maintaining, or increasing, dividends over time.
Mr Lightfoot-Aminoff comments: “Blue chip companies have greater potential to weather recessionary periods, as their reputation and product strength ensure resilience of demand for their goods and services.”
The current cost of living squeeze may result in consumers cutting back spending on discretionary items such as electronic products and leisure activities. However, it is more difficult to reduce expenditure on essential items such as food, petrol, utilities (oil, gas, electricity, water and broadband) and healthcare products.
Some blue chip companies, including low-cost supermarkets and discount retailers, may even experience a rise in demand during a recession.
Due to the stability of their earnings, the share prices of blue chip companies tend to be less volatile than those of smaller companies. The beta value is a measure of volatility and compares the ‘standard deviation’ of returns away from the average returns for the index.
According to the Financial Times, Cineworld is currently trading on a beta of 3.6 compared to 0.4 for United Utilities Group. That means that Cineworld’s share price is nine times more volatile than United Utilities compared to the index as a whole, with the average beta for the index being 1.
While volatility can create an opportunity for short-term trading, a high level of volatility can make it more difficult for investors to obtain the best price for when buying or selling shares.
Blue chip companies have the advantage of significant financial firepower to draw upon in an economic downturn. They are typically cash generative, with large cash reserves, which enables them to weather a dip in earnings.
A strong balance sheet also allows blue chip companies to make acquisitions to increase their market share in existing or new markets. They can also access debt at a lower cost than smaller, less-established companies. As a result, it is rare, although not unheard of, for blue chip companies to fail.
Although blue chip stocks typically have stable earnings, the rate of growth tends to be lower compared to other stocks due to the types of markets they operate in.
For example, software giant Microsoft has achieved a five-year growth in earnings per share (EPS) of 24% according to data from the Financial Times. By comparison, consumer staples manufacturer Unilever has achieved an equivalent EPS growth of only 5%.
Although valuation multiples need to be considered alongside earnings (more of which later), in theory, higher earnings growth should result in a higher share price in the future. Indeed, Microsoft shares have almost quadrupled in price over the last five years, whereas Unilever’s share price has fallen by 8% over the same period.
Mr Lightfoot-Aminoff says: “A focus on yield can come at the expense of growth and can signal to others that the firm offers a lack of growth opportunities in the future.”
He adds that size and stability can also reduce flexibility, as blue chip companies “often struggle against their smaller, nimbler peers, who may be disrupting their business.”
Although blue chip companies aim to keep a consistent dividend policy, dividends are not guaranteed. A fall in dividends can be a particular issue for income-seeking investors who are willing to sacrifice potential share price upside for the dividend stream from blue chip stocks.
According to investment group abrdn, nearly half of the FTSE 100 companies cut, suspended or cancelled their dividends due to the pandemic in 2020. Whilst this was an exceptional event, companies suffering a sharp fall in earnings may be forced to reduce dividends.
Similarly, some of the bumper dividends recently paid by mining and energy companies will be more difficult to sustain going forward.
Investing in blue chip companies can help to diversify an investment portfolio as their share prices may hold up better in a recession than growth stocks. However, their share prices are also impacted by the same macroeconomic and country-specific factors as non blue chip shares.
As a result, investing in an asset class that is less correlated to global stock markets, such as gold or property, may provide investors with a more balanced and lower risk portfolio.
A company’s share price is a function of forecast earnings and investor appetite, or demand.
One measure of valuation is to compare the price-earnings ratio of shares – the price that investors are prepared to pay now as a multiple of current earnings.
A higher price-earnings ratio means that investors are prepared to pay a higher multiple of current earnings for the share in the expectation it will deliver higher returns in the future. Blue chip stocks tend to trade on lower price-earnings multiples than growth stocks for this reason.
According to data provider FTSE Russell, the FTSE 100 index is currently trading on an average price-earnings ratio of 13. Blue chip stocks such as consumer staples, financial services and commodities account for 60% of the FTSE 100, and higher growth technology stocks only 1%.
By comparison, the average price-earnings ratio for the FTSE US index is much higher at 22. Technology stocks account for 60% of the FTSE US, meaning that investors are willing to pay a higher price now with the expectation of higher earnings growth from these stocks in the future, compared to blue chip stocks.
Of course there is also significant variation in the valuations of blue chip companies, with drinks company Diageo trading on a price-earning ratio of 25, compared to 6 for Lloyds Banking Group.
However, the lower valuation of blue chip stocks may reduce the risk for investors as these valuations are based on more modest earnings forecasts.
Companies trading on heady valuations on the promise of ambitious growth targets can suffer significant share price falls if earnings fail to meet investors’ expectations. This has been the case for Netflix and Meta who have been punished with a 50% fall in share price this year after announcing disappointing results.
You can buy shares in UK and overseas blue chip companies on most trading platforms, and it’s worth considering the following points:
Investing in a basket or portfolio of blue chip stocks can provide investors with potential upside if share prices rise, without the risk of an individual company performing. There are two main options:
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Having worked in investment banking for over 20 years, I have turned my skills and experience to writing about all areas of personal finance. My aim is to help people develop the confidence and knowledge to take control of their own finances.