Blue-chip stocks may give the blues too

While the intrinsic risk is lower, going blindly for them without looking at the price level can lead to loss of capital

Financial advisors often suggest that novice investors choose either large-cap stocks or large-cap mutual fund schemes as their vehicle of choice. While the advice is well meaning and these are good options, such vehicles are not necessarily ‘safe’ because they are ‘blue-chip’ in nature.

Some standard definitions of the term ‘blue-chip’ are:

• “They are stocks of well-established and financially sound companies which have demonstrated their ability to pay dividends in both good and bad times. 
   
• “Stocks of leading and nationally known companies that offer a record of continuous dividend payments and other strong investment qualities.”

Both these definitions connote ‘intrinsic safety’ with high visibility in terms of dividend distributions. However, they do not mention anything about safety against capital losses.

There is another interesting explanation for the term blue chip. In casinos the coin with the highest denomination was blue in colour and, hence, stocks deemed to be the highest in terms of quality were conferred this sobriquet. Now this is paradoxical indeed, considering that buyers of blue chips like to distance themselves from day-traders and the penny stock aficionados whom they look down upon as gamblers.

Investors can be divided into various categories based on the degree of safety that they desire in their investments. While every equity investor wants to eschew market price risk to the maximum extent possible, one of the most naïve ways of doing it is through the indiscriminate purchase of 'Blue Chip' stocks.

As in the case of several other popular perceptions, this strategy, too, may promise more than it can deliver. Here are two reasons:

Such are already “discovered” stocks. Hence, they are well tracked by analysts, the media, etc. Consequently there is virtually no “X” factor in them. Every small development in the company is analysed to death. Hence, there is hardly any edge that one can have by choosing such stocks.

These stocks are usually more liquid as compared to the rest of the market. Hence, they are liked by institutional investors such as mutual funds and insurance companies, not to mention the Foreign Institutional Investors. Also, due to the familiarity factor, they usually command a valuation premium to the lesser known names.

Now, liquidity is not really a critical factor for small investors as their actions usually do not move markets. On the other hand, many a time blindly buying a “Blue Chip” irrespective of the valuations may cause more harm than good.

Besides these points, the core assumption that 'blue chips' have less price risk embedded in them could be questioned. Sure, the intrinsic risk is lower, as many of these have high market shares and strong balance sheets. However, purchasing high-quality stocks at any price and at less than sensible valuations may actually increase the risk of permanent loss of capital.

There have been manias like the “Nifty Fifty Mania” in the USA in the mid 1970s wherein investors, after being burnt in small-cap stocks madly bought the big names believing them to be a safe haven.

However, this led to stratospheric valuations for these stocks and the ones who were unable (or unwilling) to sell out on time nursed their wounds for nearly one decade, before the next bull market in those stocks began. In India, too, the story of investors who suffered huge losses through the purchase of Infosys Technologies at a trailing PE ratio of close to three figures in early 2000 is legendary.

Finally, this elite club does not offer a 'Life Membership' option. Names like Orkay, Hindustan Motors, ACC, Indian Rayon etc. were regarded as blue chips at one time. Today, some of those companies, though existing, are not thriving the way they used to. Also, many who were part of this hallowed list have ceased to exist.

Threats in the form of dynamic environments, both, external and internal to the company, are always present. Hence, one cannot adopt a

“Buy and Forget” approach even in the case of blue chips.

In fact, it may be more pertinent to apply the blue-chip filter while investing in a company's debt instrument (say a Fixed Deposit or Debentures) as the chance of a 'blue chip' company defaulting on its debt servicing obligation is certainly lower as compared to a mid-cap company and, hence, an investor's principal will be safer.

In the case of equities, a 'good' company's management will not come to your rescue if you suffer capital loss because you have ignored the price-value equation.

A judicious blend of large and small companies appears to be the best way ahead. In a lighter vein, one can choose good mid-cap companies by terming them ‘emerging blue-chips”. In case you feel stock selection is not your forte you may always outsource the task to a competent mutual fund or Portfolio Management Scheme manager. However, please ensure that while doing so, you are not seduced into only choosing schemes containing the word 'Blue Chip”.

The author is Head – Marketing PPFAS Asset Management Private Limited