Blue-chip stocks have a history of strong earnings and impeccable income sheet, and are likely to generate above industry average rate of returns
The National Stock Exchange’s 50-share index Nifty crossed the 10,000-mark last week and mutual funds are pumping money into the markets driving up stock prices to new highs every day. Blue-chip shares are expected to be firm and reliable that will deliver good returns consistently to investors.
The word ‘blue-chip’ for shares might have probably derived from the term ‘blue-blooded’ which is used to describe a person of royal descendant. Similarly, the term ‘blue-chip’ given to some selective shares indicates a similar connotation in the family of shares. In other words, they are the best shares that you can own, a kind of crème de la crème of the entire stock market.
Generally, blue-chip stocks have high market capitalisation. Market capitalisation is nothing but the number of shares outstanding in a company multiplied by its current price. These shares are the most liquid ones. Liquidity here refers to the ease with which a share can be converted into cash. A share with higher liquidity implies that at any point of time there are adequate number of buyers and sellers.
Institutional investors and mutual funds also park significant amount of their money in these shares. They have their own competitive advantages that make them possible to earn higher sales and profitability. They are the largest companies in their own sectors. Owing to their size there are stable in their earning power that than of other comparable companies. So, the volatility in such stocks are relatively less. Due to the above attributes, even conservative investors prefer to hold blue-chip stocks.
What is a blue-chip stock?
Generally, blue-chip stocks have a history of strong earnings, increasing dividends and an impeccable balance sheet. These shares are of companies that are likely to be in the top ten list of its own sectors for the next ten years or so. If a company is part of the leading indices of the country such as Nifty 50 or Sensex 30 you can consider its shares as either blue-chip shares or moving towards acquiring that status.
Blue-chip stocks exhibit a strong balance sheet and income statement especially when you measure them on parameters like interest coverage ratio, return on equity, geographical presence, diversity in product line and, most importantly, operating cash flows. Essentially, you are identifying shares that are going to generate above industry average rate of returns.
Are they safe forever?
The answer is not really a ‘yes’. A company might lose out its status of blue-chip if it fails to fulfil the above characteristics. A former blue-chip stock can even go into bankruptcy, as it happened in the case of Eastman Kodak. It could be possible that you bought a blue-chip stock at an over valued price as generally blue-chips command a premium. This is possible as the blue-chip stocks may not be always available at a fair price.
To conclude, there is always a risk associated with shares, irrespective of whether they are blue-chip or not. The key to success in the stock market is the price at which you buy the share and the time when you buy it and the price at which you sell it.
The writer is associate professor, finance & accounting, IIM Shillong