The term “blue chip” originated amongst gamblers, where it is used to refer to the gambling chip with the highest value. Today, this term is commonly used in the stock markets to describe companies that are, in some way, superior.
I will thus be adopting a definition similar to that of the Singapore Exchange (SGX) – a blue chip is a “common stock of a nationally known company, with a long record of profit growth and dividend payment”. These companies are usually reputed for its quality management, products, and services.
However, do these stocks provide superior returns?
Behavioral Biases of Investors
First, let us run through some behavioral issues that affect our decision-making.
Studies have shown that investors have the tendency to build portfolios on assets they are familiar with. This bias can be explained by investors’ distorted probability judgement due to over-optimism with familiar investment instruments, hence underestimating the risks.
Many blue chip equities hold household names that retail investors are familiar with. Furthermore, these stocks often receive heavy coverage by analysts and attention from the media. As such, it is no wonder that blue chip equities are popular choice among investors.
The Pros of investing in Blue Chip equities
Blue chip stocks are a popular choice among investors because of their stable earnings performance, even during harsh economic conditions. Blue chip companies are often backed by business models that have proven to be successful in achieving consistent growth and strong cash flows. Furthermore, market prices of blue chip stocks seldom fluctuate much, and thus, such companies usually declare dividend payments to make up for the lack of capital gains opportunities.
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
In essence, blue chip stocks are a safe option for preserving capital, where dividend payments help to protect against inflation.
The Cons of investing in Blue Chip equities
Buying into higher-priced yet stable blue chip companies deprive an investor of exposure to larger capital gains from small-cap and other growth stocks. While blue chip stocks provide a relatively constant stream of passive income, they are usually accompanied with slower growth and lower return. As compared to growth stocks and real estate investments that carry higher risk and returns.
The lower returns can be attributed to the fact that blue chip companies are already well established, and thus the potential for outmatching the market growth is very slim.
In fact, these stocks drive most market indices, thus the returns would not deviate too far from the indices themselves.
So, to answer the question, should I invest in blue-chip stocks?
To find out, we now look into a sample study of common stocks on the New York Stock Exchange (NYSE), American Stock Exchange (Amex) and NASDAQ over the duration from 31st July 1963 to 31st December 2013.
On sorting the various stocks into five quintiles, ME1 being the smallest in market equity and ME5 being the largest (a proxy for blue-chip stocks), we see that only ME5 had underperformed the market. We also see a sharp difference in nominal value between ME1 and ME5 with a dollar invested in ME1, ME2 and ME3 returning $27.36, $33.54 and $33.39 respectively while ME5 provided a return of $9 only.
The finding is consistent with what was initially proposed by Fama and French (1992), in which it was suggested that smaller stocks would have a premium over larger stocks.
We see this from the figure above on Small-Cap Premium where small-cap stocks have underperformed their larger-cap counterparts for decade long spans such as during the 1950’s and 1980’s.
Too good to be true?
The numbers seem to indicate that we should not invest in blue chip stocks right? Before we jump into any conclusion, there is yet another consideration we have to factor in – risk.
In finance, the general basis of measuring risk would be volatility (standard deviation) and the results of the portfolio volatility are as per table below.
We see that ME5 still provides the lowest risk against all other quintiles. However, before we form any conclusions, we ought to know what is the risk-adjusted return, that is, the average return earned in excess of the risk-free rate per unit of volatility. This also known as the Sharpe ratio, an industry standard for risk-adjusted returns with the following formula,
Simply put, as investors, we know that higher risk generally translates to higher returns.
However, how do we justify the risks we take? To what extent are we getting returns on the risks that we take?
Therefore, we should strive to achieve the highest average return in excess of the risk-free rate per unit of volatility, that is, the highest Sharpe ratio. In other words, smaller cap stocks (ME1 to ME4) have proven to be a better choice compared to blue chip stocks (ME5) on a risk-adjusted basis.
Now that we have seen the calculations, it is clearly evident that the small cap premium exists, consisted with the research by Fama and French. Furthermore, small cap stocks provide a higher Sharpe ratio than blue chip stocks. All in all, do keep these findings in mind on your next investment and always question if your behavioral biases are at play!
This article was contributed by Quah Tian Yong, a NUS Business Dean’s Scholar with a Degree in Business Administration, majoring in Accounting & Finance. With an avid interest for personal finance and investing, he has recently completed CFA level 2 and aspires to pursue a career in Equity Research.
Featured Image source: Wyatt Research