What are blue-chip stocks?

In any field, there are players that are well-established. They are known not only by their names but also by the names of the products they sell. Besides this, such companies have a sufficiently long presence in a sector. In that long period of existence, these well-established companies also score well on important parameters of growth and earnings. They have a long history of well-managed operations. They are called ‘blue-chip stocks’. Many investors prefer to include these stocks in their portfolios because they offer stability even in the most volatile times in the markets. Let us understand in greater detail the characteristics of a blue-chip company. This will help us understand why these stocks don’t lose their charm even in weak phases of the market. 

The genesis

Before we go into the definition of a blue chip stock, we should know the origin of the term. Though there is no official record about it, some attribute it to blue chips – the costly chips in the game of poker. Some say that the term was first used in 1920 by Oliver Gingold—an employee of a company that would later become Dow Jones. He used the expression blue chips to refer to high-priced stocks – those that were quoting above $200.

Over the years, the term ‘blue chip’ has evolved to distinguish high-quality stocks from high-priced stocks. Many a time, these two notions overlap as investors are willing to pay a high price for high-quality stocks. 

Blue-chip stocks are those which are backed by companies that have a large business with a long history of sound operations. These companies are well-funded and generate ample cash from their business. Generally, they pay dividends for many years in a row. Many times, these companies do well in the bull market. They also manage themselves well in a tough business environment and emerge stronger when the economy rebounds. Blue-chip stocks in some cases are household names as the goods and services they produce are consumed by a large number of consumers. 

Characteristics of blue-chip companies

Large size

Since these companies are in business for a long period of time, they are large in terms of market capitalization. Some even export their goods and services. Rising demand from investors sustains interest in these counters. 

Market leaders

These companies grow to become market leaders in their respective sectors. They are generally among the top 2 or 3 companies in their sector. Investors prefer to own such blue chips as they tend to have large market share and have the potential to generate large profits in the future.

Strong financials

These companies have sound balance sheets to support their business. When they need funds, they can easily raise money at relatively lower interest rates as compared to small and mid-sized companies. Since they generate a large amount of cash, which they can either share with shareholders by paying dividends or do large share buybacks to improve their valuations. Nowadays, blue-chip companies in high-growth emerging sectors do not pay high dividends. Instead they use the money to allocate more capital to their high growth businesses.

Low volatility and well tracked

Blue-chip stocks are well-recognised by market participants. They are also present in many market indices such as the Nifty 50 or the BSE Sensex. These blue-chip stocks are tracked by many analysts and the news flow is captured prominently in the mainstream media. Their share price generally reflects all available information about them. 

Investors looking for relatively little volatility in their portfolios invest in blue-chip stocks. Such stocks keep rising at a predictable rate of growth, in line with the growth in earnings of their underlying business. These stocks are not as volatile as mid-caps and small-caps. Investors buy these stocks with a fairly long-term view. 

Preferred by large-cap funds

Large-cap equity funds invest at least 80% of their money in large-cap stocks. These funds buy a large number of Indian blue-chip stocks from sectors such as banking & financial, energy, communication, and fast-moving consumer goods. Some large-cap equity funds in India use the word ‘blue chip’ even in a scheme’s name. 

Taxation 

Dividends announced by blue-chip stocks are taxable. Gains on sale of stocks held for more than one year are termed as long-term capital gains and taxed at the rate of 10% without indexation, if gains exceed ₹1 lakh in a given financial year. Gains on sale of stocks held for less than one year are treated as short-term capital gain and are taxed at 15% rate of tax.

Summary

Having blue-chip stocks in a portfolio helps contain downside. Buying blue chips in a bear market or when stock prices are too depressed can be a good investment strategy. However, relying solely on them may deprive investors of investment opportunities in the mid-and-small-sized companies, which grow at a fast pace. 

Though blue chip stocks are largely stable on bourses, there are situations when some blue chips have gone bankrupt. For example, blue chip stocks like Lehman Brothers, Washington Mutual and General Motors filed for bankruptcies during 2008-09. Despite this, historically, it has been observed that the fall in the share price of blue chip stocks in a bear phase is not as steep as their mid-and-small-sized counterparts.