The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we’re focusing on an investment term often referenced in discussions about stock market performance and attractive equities: blue-chip stock.
What is a Blue-Chip?
A blue-chip is a reputable, widely recognized, and financially sound company that typically sells well-known, industry-leading products and services. In other words, a blue-chip is a company with a strong reputation and a long track record of financial success. It is a stable company that has been around for a while, and one with a name that is highly recognizable. Due to a blue chip’s well-established profile and seasoned status, such a company is known to weather economic and market downturns and maintain profitably amid unfavorable economic conditions. This ability contributes to a blue chip’s record of long-term stability and reliable growth. A blue-chip stock is the equity of a blue-chip corporation available to investors. Because blue-chip corporations have proven track records of consistent growth and success, blue-chip stocks are usually viewed as safer investments.
Why the Name “Blue-Chip”?
The term “blue chip” has its origins in the poker world in which chips are used for gambling and chip colors represent various dollar amounts. A blue-chip is – you guessed it – typically the highest value chip in the world of poker and gambling, hence the name adoption for the companies and corporations with the greatest values in their respective industries. The term “blue chip” was first used to describe high-priced stocks in 1923 by an employee at Dow Jones when he noticed big-name corporations trading at $200 or more per share, a high price tag for a stock at the time. Nowadays, blue-chip stocks more accurately refer to equities of high-quality companies with long legacies in the stock market as opposed to exclusively denoting corporations with a high cost per share.
Characteristics of Blue-Chip Stocks
Blue-chip stocks are the leaders of their sectors – they define the industries they are in, and they have proven records of long-term stability. These corporations are financially sound with years and years of proven profitability to their names. All blue-chip corporations are generally, but not always, notable, household names. Some companies that fall under the blue-chip category include Alphabet (Google’s parent company), Disney, Bank of America, Starbucks, IBM, Microsoft, Nike, and Goldman Sachs, to name a few. The total number of blue-chip stocks on the market depends on the criteria used to classify such companies. There are four main criteria that typically qualify a company as a blue-chip and that all blue-chip stocks have in common:
- Large market capitalization. Market capitalization refers to the total value of all of a company’s shares of stock, meaning it is a measure of the size and value of a company. Blue-chip stocks tend to be large-cap or big-big stocks, meaning the companies have a market valuation of $10 billion or more.
- Inclusion in a major market index. Due to their size and valuations, blue-chips stocks are often selected to be in major market indices like the S&P 500 (the index that tracks the performance of 500 large companies listed on the U.S. stock exchanges), the Dow Jones Industrial Average or DJIA (colloquially referred to as the Dow, this index comprises 30 prominent companies listed on exchanges in the U.S.), and/or the Nasdaq 100 (an index of 100 of the largest non-financial companies listed on the Nasdaq stock exchange).
- Significant and stable growth history. Blue-chip stocks have long histories of consistent profits and have weathered various market cycles. These stocks display years of consistent growth and stability with less volatility.
- Record of issuing dividends. Although not all blue-chip stocks issue dividends – regular payments made to investors from a company’s revenue – a majority of these stocks do, as dividend-paying companies are often mature, well-developed corporations that no longer need to invest as much revenue back into the company for future growth.
- Strong balance sheet. Blue-chip companies tend to have rock-solid financials, hence these companies’ abilities to withstand economic challenges that derail smaller, younger entities. Balance sheets report a company’s assets, liabilities, and shareholder equity, and blue-chip companies often have little to no debt and a high return on equity and assets.
The Pros and Cons
Blue-chip stocks are often seen as less volatile investment options due to the companies’ well-established status and tenure in the economy and stock market. Investors who tend to be more conservative and have a low-risk profile see blue-chip stocks as safer, reliable investments, and, for that same reason, these stocks are also popular among retirees and those nearing retirement who want to decrease the risk in their portfolios and preserve capital. Blue-chip stocks are also viewed as prudent investments because of the consistent dividends that most of these corporations pay out to investors, which is a welcomed source of passive income for investors.
Although blue-chip companies are known to withstand challenging market cycles and economic downturns, these companies can be compromised and can have failure. The Great Recession witnessed a period of global economic downturn from 2007 to 2009, which saw the bankruptcy of General Motors and the collapse of Lehman Brothers, along with several other prominent European banks. That being said, although blue-chip companies have a lot of pros that make them seem impenetrable by failure, some of these companies can still see adversity in times of extreme economic stress. These stocks are not immune to market and economic downturns, but blue chips have displayed a reliable history of weathering such storms and bouncing back. For example, blue-chip stocks have been among the most secure holdings throughout the COVID pandemic.
Investing in Blue Chips
Investors often turn to blue-chip stocks for their dependable financials and consistent dividend payments, and while history has shown that it is largely true that these stocks can survive a variety of market challenges and downturns, keep in mind there is no guarantee of that. Although blue-chip stocks are appropriate core holdings, diversification within a portfolio remains prudent, as no single sector or stock classification should comprise an entire portfolio. When looking for blue-chip investment opportunities, investors can buy individual shares of blue-chip stocks directly or buy shares of mutual funds and exchange-traded funds (ETFs) that invest in blue-chip stocks and have exposure to such companies.
Final Points
Blue-chip companies are large, globally recognized corporations with exceptional reputations, and the stocks of these companies have a strong performance history and have attractive dividends that make these equities appealing core holdings within a portfolio. Remember that diversification still reigns supreme, as no investment is guaranteed to withstand unpredictable market and economic adversity. Consult your financial advisor before making any changes to your portfolio and allocation.
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