Blue-chip stocks tend to be among the most stable, best-performing stocks available to retail investors. These stocks allow investors to buy shares in stable companies that have a large market capitalization.
However, the “price” that investors pay for that stability is muted (but not nonexistent) organic growth. With that said, blue-chip stocks deserve a place in every portfolio. In this article, we’ll explain why there’s never a bad time for investors to buy the blue chips.
What Are Blue-Chip Stocks?
Blue-chip stocks are the very best companies in their respective industries. Their large businesses typically have many years, if not decades, of successful operations to back up the valuation. The phrase "blue chip" comes from poker because blue chips have the highest value. Blue chips may not be the answer if cheap dividend stocks are the goal.
In other words, investors looking for value may not want to invest in blue chips because they tend to come with higher price tags than their competitors. For example, McCormick & Company (NYSE: MKC), which has an unblemished 35-year history of dividend increases, trades at nearly 30x its earnings, while the Kraft Heinz Company (NASDAQ: KHC), which does not have a history of dividend increases, trades for only 15x its earnings.
So, what are blue-chip stocks? They are the leading companies in well-established industries, far from risky penny stocks.
What Makes a Stock a Blue-Chip Stock?
The qualities that make a blue chip are fairly general but come down to its quality as a business. How long has it been operating? How strong is the brand? How good is the revenue and, more importantly, the cash flow? The longer the company has been in operation, the more established its brand, the better the cash flow, and the "bluer" it is. In most cases, blue-chip companies pay dividends as dividend growers because they want investors to buy and hold shares.
Were you wondering about investing in blue-chip marijuana stocks? Think again. Marijuana stocks have not been around long enough to be blue-chip stocks.
Are blue chip stocks a good investment? That depends on the investor. Blue-chip stocks are good stocks to invest in but may only be right for some portfolios.
A Goldilocks Combination of Growth and Value
Should you buy growth stocks? Should you buy value stocks? This becomes a circular argument among many investors. And when investors turn to the financial press, they find that analysts and advisors will offer different opinions. The truth is that over the years, there’s a case to be made for both.
However, the downside to having a portfolio that is overweight growth stocks or overweight value stocks is that it is likely to underperform at different times. That’s the benefit of blue-chip stocks.
What are blue chip stocks? They offer the best attributes of growth and value stocks. And this combination provides a smoothing effect for portfolios. These stocks may not outperform pure growth stocks during robust bull markets, but they are also likely to be among your “less bad” performers during market corrections.
Mature Companies in Mature Sectors
What is a blue chip company? One reason that drives the consistent performance of blue chip stocks is that many of them are in defensive industries. Defensive stocks are stocks of companies with a proven track record. These companies have products and services remain in demand no matter what is going on in the economy. An example of this would be Johnson & Johnson (NYSE:JNJ). The company’s personal care products are in demand by consumers. Another example is Coca-Cola (NYSE:KO) which is a favorite of no less an authority than Warren Buffett.
Both companies are in extremely competitive sectors. However, these companies have loyal consumers that are willing to seek out their brands at the expense of their competitors. This gives these companies pricing power.
Is Amazon a blue chip stock? Learn more.
Rock Solid Balance Sheets
That pricing power leads directly into another shared trait of blue chip stocks. These companies have strong fundamentals that make them some of the highest value stocks. For example, many companies have pricing power means that allows them to pass along increased producer costs to the consumer. This means that the companies are more likely to retain their operating margins, which will typically translate to more stable earnings.
This pricing power also means these companies generate positive free cash flow (FCF) which they can use to reward shareholders. In many cases this is done in the form of a dividend. A dividend payment is a way for shareholders to “collect rent” on the shares they own. In addition to paying dividends, many of these companies will issue stock repurchase (stock buyback) programs which is another way to make the stock price more attractive and encourage other investors. Learn more about how to find blue chip dividend stocks.
Why Invest in Blue-Chip Stocks?
Blue-chip stocks offer stability, safety and dividends through companies with well-entrenched businesses that have proven they can stand the test of time (and pay dividends while doing it). Blue-chip stocks also tend to be substantial businesses, large or mega caps, with deep moats related to their brands, product(s) or industries. They offer an element of safety and income for investors in the long haul. Among the many benefits is reduced volatility and, in many cases, market-beating dividend yields. When it comes to the stock market and what risk-averse investors should focus on, there are blue-chip stocks and everything else.
Reinvesting Dividends and the Power of Compounding
In addition to receiving dividends, many blue chip stocks give investors the ability to reinvest their dividends. Reinvesting dividends is a solid strategy that can boost total return and deliver the benefit of compounding.
For example, if you own $1,000 shares of KO stock in June 2022, you would be in line to collect $5,520 in annual dividends. By reinvesting those dividends you would buy 22.66 new shares without having had to add any of your own money.
But there’s an even bigger benefit. Since Coca-Cola pays its dividend quarterly, you would buy 5.66 shares per quarter, compounding your dividend payment for the next quarter and so on and so on. Here’s an example not including fractional shares:
Quarter 1 = 1.38 x 1005/4 =346,72
Quarter 2 = 1.38 x 1010/4 = 348.45
Quarter 3 = 1.38 x 1015/4 = 350.17
Quarter 4 = 1.38 x 1020/4 = 351.90
And keep in mind that many of these companies increase their dividends every year. Rising dividends increase the benefits of compounding.
Other Benefits of Blue-Chip Stocks
Consistent performance, solid balance sheets, and the opportunity to collect dividends (and benefit from the power of compounding) should be enough to convince you that blue chip stocks have a place in your portfolio. But if you’re still not convinced, here are a couple of additional reasons why blue chip stocks have a place in every portfolio.
First, investors should consider the benefit of diversification. Blue chip stocks are a way for growth investors to add a value component. They can also give value investors some exposure to growth. But diversification also means broadening your sector exposure. One way to do this is to find mutual funds and exchange traded funds that specialize in blue chip stocks.
Many investors rely on blue chip funds to provide sector diversification. However, quality blue chip stock can do some of that work as well. For example, a stock like British Petroleum (NYSE:BP) provides exposure to the oil and gas sector as well as the commodities market.
And speaking of ETFs, another benefit of blue chip stocks is that investors can find an ETF that specializes in blue chip stocks. This is a great option for investors who don’t want to purchase individual stocks or simply want a more set it and forget it option for this percentage of their portfolio.
Another way for investors to gain exposure to blue chip stocks is through an index fund that benchmarks the Dow Jones Industrial Average (DJIA). That’s because many Dow stocks have blue chip status.
Learn more about how to invest in blue chip stocks.
How to Invest in Blue-Chip Stocks
Investing in blue-chip stocks is easy. Here are a few tips on how to buy blue-chip stocks and build a winning portfolio.
Step 1: Build a watchlist of blue-chip stocks.
The first step is to build a watchlist of blue-chip stocks. The list should be diversified and include stocks you might want to buy. You can put together a watchlist of stocks on many stock news sites, including on MarketBeat. The purpose of the watchlist is to develop a list of the stocks you want to build positions in and then keep track of them, waiting for opportune entry points. Entry points are times when the stock's price pulls back from higher levels, offering better value and yield for investors.
Step 2: Pick the right blue-chip stocks.
After building the watchlist, do some more research and decide which blue chip stocks are right for you, such as reviewing the fundamentals of each stock you're considering, such as cash flow and return on assets. The watchlist is something that will evolve. Investors can add new stocks they find or become interested in and also cut out any that don't maximize the portfolios' goals. What makes the right blue chip stocks depends on the investor, the goal of the portfolio and the allocation targets for holdings. A $1,200 stock may be attractive for many reasons, but the price is so high it may be a problematic fit for smaller portfolios. At face value, a single share is worth more than 10% of a $10,000 account and may expose it to undue risk.
Step 3: Wait for the right entry points.
After choosing the target stocks, select your entry points or attractive price points. You can use price points to set limit orders for the blue-chip stocks in a brokerage account. You can base price targets on past price action, technical indications like the 150-day EMA or even the analysts. The analysts' targets, the consensus target, is a closely watched figure for most blue-chip stocks and will often produce strong moves when reached, touched or crossed by the price action.
Step 4: Repeat, choosing the right blue-chip stocks.
After making the first buy, go back to step two and repeat the process. Choose the right stock, pick a target entry and set the order. Do this regularly to take advantage of price swings. Building a portfolio of blue-chip stocks is not a single purchase but repeated buying that creates larger positions over time. In this manner, dividends can be compounded and used to enhance returns.
Pros and Cons of Investing in Blue-Chip Stocks
As with all investments, there are pros and cons to investing in blue chip stocks. Blue-chip stocks have many attractive qualities but are not suitable for all investment accounts, strategies or investors. You also want to consider sectors and industries as well. Blue-chip tech stocks don't perform the same as blue-chip materials stocks or blue-chip consumer staples.
Pros of Blue-Chip Stocks
Let's take a look at the benefits of investing in blue-chip stocks:
- Growing revenue and cash flows: Blue-chip stocks are well-established businesses with stable, if not growing, revenue and cash flows.
- Weathering bad markets: Blue-chip stocks can be counted on to weather ups and downturns in the economy but may perform differently, depending on sector and industry.
- Steady, reliable dividends: Blue-chip stocks tend to pay reliable dividends and many are dividend growers. The distribution can help attract buy-and-hold investors and reduce market volatility in both cases.
- Deep moat: Blue-chip stocks may come with a deep moat based on a product, brand or business.
Cons of Blue-Chip Stocks
What are the downsides?
- No capital gains: The biggest con of a blue-chip stock is that it can be dead money concerning capital gains. In many cases, blue-chip stocks aren't growing anymore. If they are, it could be faster and the growth could be easily priced into the market. These stocks may trade within a trading range or have very slow uptrends to drive their share prices.
- Not the most active stocks: Blue-chip stocks are not the most active ones but are heavily owned and in liquid markets.
Blue Chip Stocks Have Something to Offer Every Investor
Are blue-chip stocks a good investment? Investors with a high risk tolerance may choose to invest in small-cap or mid cap companies. The stocks of these companies provide the opportunity for outsized future growth. However, these securities also add the possibility for an outsized risk to the downside.
For those investors blue chip stocks can be a viable alternative. Having a few of these stocks in your portfolio, even if they occupy a very small percentage, can help offset the gut-churning volatility that can affect every investor’s actual risk tolerance.
Conversely, more conservative investors need not stick to fixed income, low growth assets. Buying blue chip stocks can offer the opportunity for capital gains that may, in many cases, outpace the rate of inflation which is a concern with fixed-income investments. And since many blue chip stocks pay dividends and rising dividends at that, investors have another avenue for collecting income from these high-quality stocks.
Investing in blue-chip stocks is a great way to build a portfolio. However, not all blue-chip stocks are suitable for all investors at all times. Build a watchlist of blue-chip stocks first, then pick the right ones and buy them when they present the best opportunities. Over time, you can build a large portfolio of dividend-paying blue-chip stocks to sustain a comfortable retirement.
FAQs
Have questions about blue chip stocks? We answer some of the most commonly asked questions here.
How do I invest in blue-chip stocks?
Learn what a blue chip stock is, build a watchlist and then buy the most attractive stocks on a regular or semi-regular basis.
Where does the term "blue-chip" come from?
"Blue chip" is a reference to poker. In poker, blue chips are the highest-valued and most desirable chips. In the stock market, blue-chip companies are the largest, most valuable and most desirable stocks available on the stock market.
Should I buy blue-chip stocks?
Buy blue chip stocks if you are looking for safety and dividends or if you are a buy-and-hold-forever type of investor. They should fit the style and goals of your portfolio.
