Not all blue chips are made equal

Blue chip’s not a underwrite for investment success

Blue chip stocks are considered safe investments because they are the largest and most recognised companies in the world. In most cases large companies will be safe investments however size does not always guarantee safety. In some cases, blue chip companies can become complacent and subject to disruptive competitors which is why investors should be vigilant when investing in traditional blue chip stocks.

Companies that are already very large and have dominant market share need to use their competitive advantage wisely to maintain their market dominance. It is imperative they do not rest on their laurels. For the largest companies in the market, the risk of being surprised by incumbent competitors is much greater than the potential to gain more market share. In other words, blue chip stocks have limited upside but face greater downside risk.

There are many examples of market leaders being made redundant in the current age of digital disruption, but I draw my experience from an example that was played out over many decades. The example is of Fairfax Media or Eastman Kodak which, in its prime, were iconic media and photography companies respectively.  

The lesson in Fairfax and Eastman Kodak is that even the bluest of blue chips is not immune to downfall. The downfall was not due to one discrete event, but was a series of misjudgments by management over several decades.

Blue chips: the Growers, the Status Quo and the Faders

1968 BHP North Broken Hill Conzinc Rio Tinto Hamersley MIM
1978 BHP Conzinc Rio Tinto MIM Hamersley Bank of NSW
1988 BHP Westpac Banking Alumina Conzinc Rio Tinto National Australia Bank
1998 Telstra National Australia Bank BHP Westpac Banking ANZ Banking Group
2011 BHP Billiton CBA Westpac Banking Corp ANZ Bank Group National Australia Bank
2019 CBA BHP Group Westpac Banking Corp CSL ANZ Banking Group

Globally its musical chairs

In the United States at the turn of this century, General Electric (GE), Microsoft and Exxon Mobil were the 3 largest companies in the world. Investing in these companies would have generated reasonable returns (GE being the laggard of this group). Fast forward to today and only Microsoft remains in the largest 3 companies list. GE and Exxon Mobil, whilst still considered blue chip, have both fallen outside the top 10.

History tells us that in all likelihood, today’s blue chips will not remain there forever, the dominance of companies is temporary and only as good as their relevance to tomorrow’s customers. The constant evolution of the list of blue chip stocks is much like the rankings of golf players.

As a long term investor, how do we differentiate between a solid blue chip company and one that will decline over the long term? It’s not easy, and hence the cry “buy blue chips” is a gross simplification of a complex challenge. One way to filter blue chips maybe the use of Moats, the problem being that in Australia, there are few companies with wide moats and indeed many that have are have significant issues. Part of the answer lies in identifying three broad categories of blue chip stocks:

The Growers

These are blue chip companies that do not rest on their laurels. They continue to behave as a young company, spending a lot of money on innovation and reinvestment. These companies are already successful in their own right and are comfortable with new business ventures and their potential failure. This category covers a large group of companies that are usually slightly younger than the average blue chip. Nike, Tencent and Ping An Insurance Group fit within this category.

The Status Quo

Most blue chip companies fit this category. These are large companies that will continue to have some form of relevance to its customers. They have established competitive advantages but are capped by a saturated market. The Status Quo will continue performing reasonably over the long term. Microsoft, Walmart, Johnson & Johnson, Nestle and Royal Dutch Shell come to mind in this category.

The Faders

There are a minority of traditional blue chip companies that will become irrelevant over time. They may currently be the largest players in their industry, but historical success becomes their enemy. Size of the organisation inevitably slows down decision making processes and they become fixated on historical business lines. These dinosaurs will fade over time as they become sitting ducks for the Growers. In a few severe cases, they can even disappear into oblivion as we have seen with Nokia, Research In Motion (Blackberry), Fairfax and Eastman Kodak.

But how does one tell if a company will be a fader or just merely status quo?

Avoiding the Faders

If we want to invest in great companies with blue chip qualities, then we should start by avoiding companies that are likely to be faders. So what makes the perfect fader?

Complacency

Just like Fairfax and Eastman Kodak, these companies fail to constantly innovate before it’s too late. These blue chips prefer to pay out a large proportion of earnings as dividends and become value traps. The dividend holds but the capital drifts downward, Goodman Fielder and Fairfax are examples here. By leaving very little for reinvestment or by making poor decisions regarding which segments to focus on, they remain cash cows focused on yesterday’s businesses.  Complacency is often identified globally in large corporates that have below average levels of reinvestment and very high dividend payout ratios. So through what prism do we view the four big Australian banks, who have failed to invest in technology and people? Management is usually bureaucratic and may have very little long term remuneration at risk.

Irrelevance

Whilst they may be the largest player in their industry now, Faders operate in industries that can be bypassed. For example, traditional print media companies are losing business to digital advertising. With rivers of gold flowing onto its balance sheet, Fairfax failed to take opportunities in seek.com and Realestate.com and Car Sales., $1.1 billion of potential value evaporated. The more complex the business model, the greater the risk of being bypassed, because analysts and the markets find understanding the business difficult.

Too dominant

Investing in a company that is already the dominant market leader is risky. If you’re already at the top, there is only one way to go. No greater examples than Telstra, and the Australian banks, the AMP and so on.  Dominant companies have already reached maximum market penetration so the need to innovate new products is even greater. Investing in Commonwealth Bank in March of 2015 at the peak of its dominance turned out to be a risky strategy. Let’s consider Motorola in 1994 it was eventually outmanoeuvred by Nokia. Just as Nokia was the dominant leader in mobile phones in the 1990’s, it was usurped by the Blackberry which has now been surpassed by Apple and Samsung. You watch Apple and Alphabet because they are the dominant forces in their industries. Reality is that there are less risky alternative stocks that still offer the same blue chip qualities for an investor.

The sweet spot of blue chip investing

Investors should not take blue chip stocks for granted. As we have witnessed through history, investing in blue chip stocks does not guarantee safety. By systematically minimising each potential risk, an investor will naturally find themselves attracted to a certain type of company that maximises their chances of exceptional returns.  Companies that tend to be consistently expanding geographically or through new business lines won’t have a generous dividend payout ratio and provide a service that will remain valued by society over generations. Typically these companies have been outside the top 10 or twenty stocks. The problem is that the concept of blue chip is nebulous and firmly rooted in the belief that big name, big companies will deliver. The reality is that few blue chips can maintain market position and growth EPS. The granddaddy of the Australian market has some spectacular falls in its history. There are a “bunch” of unknown stocks out there that are more likely to deliver on your blue chip investment objectives – steady, resilient and sustainable investment returns over the long run, than the top 10 best known companies on the stock exchange.