Why You Shouldn't Invest in Blue-Chip Stocks

I've read it so many times from so many different investment fund managers that it must be true. Here's one manager quoted in a recent Barron's article:

There are great returns to be made in big-cap, blue-chip equities in the coming quarters.

So if some of the best minds in the market think high quality, large companies are cheap, cheap, cheap, and we should sell everything and buy them, not for just the coming quarters, but for the long term, right?

Wrong!

Pick the right shade of blue
As stock investors, we have to be selective -- even with the bluest of blue chips. The Dow Jones Industrial and S&P 500 indexes, which track the largest companies, have averaged 3.7% and 2.5% annual returns, respectively, over the past 10 years (including dividends). That's not much from such a supposedly great group. And look at how poorly the three bastions of business below fared during that same time period:

Blue Chip

10-Year Return

Citigroup (89%)
General Electric (46%)
Ford (35%)

Source: Yahoo! Finance.

Lots of people considered these companies blue chips in 2001. And many of those investors have felt lots of pain.

I do think there are big-company bargains out there for the taking. But we've got to have a plan to invest with the contenders and avoid the pretenders. I've outlined mine here in "3 Steps to Big Profits in This Crazy Market." Using it, I've found a large-cap opportunity that I'll be happy to share with you at the end of the article.

But first, here are three things to be wary of in large-cap stocks today.

No long-term growth
Large, high-quality companies should be able to use their competitive advantages to generate higher sales over time. If that growth doesn't materialize, investors head for the exits.

When investors talk about aluminum, Alcoa (NYSE: AA  ) is the name they think of. And Ford (NYSE: F  ) is not just an American icon anymore. It's also a global brand. But one look at the table below shows how investors have felt about their volatile financial performance over the past 10 years:

Company

2001 Sales

Peak Sales

Trough Sales

10-Year Return

Alcoa $22.6 $29.3 (2007) $18.4 (2009) (50%)
Ford $161.3 $176.8 (2005) $116.3 (2009) (35%)

Source: Capital IQ, a division of Standard & Poor's. Dollar figures in billions.

These companies are cyclical. And that means their returns can be volatile. So, timing is everything -- even if we don't want it to be.

Declining margins
Like clockwork, competition is always trying to bring down margins of even the mightiest giants. Times change, and new companies brings fresh, innovative ideas to the marketplace.

AT&T (NYSE: T  ) has been around for ages as a first mover in telecommunications, while Kimberly Clark (NYSE: KMB  ) has some of the most well-regarded brands in the world with Kleenex and Huggies. But look what's happened to their EBITDA (a measure of cash flow that stands for "earnings before interest, taxes, depreciation, and amortization") margins over the past 10 years:

Company

EBITDA Margin 10 years ago

Current EBITDA Margin

AT&T 40.5% 30.9%
Kimberly Clark 24.4% 17.9%

Lower margins mean smaller portions of every dollar of sales drops to the bottom line as profit, something that can scare investors away.

Multiple compression
Do you know what can happen when investors get scared? All kinds of crazy things start running through their heads. They question companies' futures and usually start selling. Stocks sales can lead to multiple compression, which can kill returns in a portfolio.

Walgreen (NYSE: WAG  ) has opened hundreds of profitable stores over the past decade. And yet is EV/EBITDA multiple has contracted from 27 in 2001 to 8 recently. The stock has returned only 22% over the decade. Even though EBITDA grew with every new store, multiple compression limited future returns.

Computer storage maker EMC (NYSE: EMC  ) also saw an explosion of EBITDA over that same time period. Its multiple compressed from 30 to 15, even excluding the bursting of the tech bubble. So despite fantastic EBITDA growth, its share price is down 30% over the past 10 years.

As investors, we have to mind the assumptions built into multiples, because investor sentiment can change quickly. If the multiple looks high, it probably is -- and trees don't grow to the sky.

Mind your cycles
By themselves, each of these warning signs might not cause a problem. In the Walgreen example, EBITDA grew fast enough to overcome the multiple compression, so investors still made some money. But if growth slows, margins decline, and the multiples compress, that's a recipe for disaster in any portfolio.

I recently chatted with fund management and Active Value Investing author Vitaliy Katsenelson about the large-cap dilemma. He used Caterpillar (NYSE: CAT  ) as an example of a cyclical company to be cautious of right now. The construction equipment maker has been hitting on all cylinders recently during the global economic recovery. But if another slowdown causes sales to decline and margins to shrink, its multiple would likely compress, bringing the stock price down in a triple-whammy.

Here's the plan
While I do think blue chips as a group are attractive, we still need to be choosy, weeding out the potential traps to find the real opportunities. We need to be especially careful with cyclical companies. They may have risen sharply from the bottom, but they can fall hard if the recovery does reverse course. To combat against this risk, I am managing my $50,000 portfolio using the following strategy:

  1. Look for strong companies in growing trends.
  2. Trade cyclicals and hold growers.
  3. Figure out the odds for success.

I've explained many times why the market has mispriced Google, making it an attractive investment over the next 10 years. It has plenty of opportunities to grow within and outside of search, has healthy margins, and isn't very cyclical.

Google popped up again using my framework above, but it's not the company I am most excited about. If you'd like to learn about the 3 strong trends and one money-making idea I see today, I'll be happy to give you a free copy of my special report. All you have to do is click here and tell me where to send it by entering your email address in the box provided.

David Meier is associate advisor of Million Dollar Portfolio. He does not own any of the shares mentioned in the article. Motley Fool newsletter services have recommended Google, AT&T, Ford Motor, and Kimberly Clark. The Fool owns shares of EMC, Ford Motor, and Google. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (23) | Recommend This Article (74)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 16, 2011, at 4:10 PM, buffalonate wrote:

    I agree. People think they are safe but there isn't a lot of growth when you are already a huge company. I don't invest in any of the blue chip companies because they upside is very limited.

  • Report this Comment On May 16, 2011, at 4:35 PM, pastreet wrote:

    Blue chips are great for a lot of reasons, but I can see the argument for somewhat limited price appreciation. Many investors can make up for this by reinvesting dividends to accelerate returns, and also waiting for a market downturn or misvaluation to cash in on the best characteristic of the blue chip stocks- their staying power and ability to snap up faster growing little guys with cash and ensure their survival.

    Pat

    www.compoundingreturns.com

  • Report this Comment On May 16, 2011, at 5:09 PM, 11x wrote:

    Small caps have been oupterforming Large caps over the past 10 years. During the 1990's, the opposite was true. Large caps outperformed, as a whole.

    Right now the valuation metrics are pointing to blue chips being undervalued compared to the red chips.

    .

  • Report this Comment On May 16, 2011, at 5:32 PM, Notfooled1 wrote:

    Meier, your logic is faulty. SOME blue chips have not done well over the past 10 years, and some of those you list as blue chips, such as Ford, have not merited that rating for many years.

    You could have listed many true blue chips, such as IBM, that have done very well over the past 10 years. Your selective cherry picking is typical of fools everywhere. Only a fool takes advice from another fool, especially a motley one..

  • Report this Comment On May 16, 2011, at 6:03 PM, rulebreaking wrote:

    As usual some of these 20yold guys who never red a fund prospectus "Past returns are not indication of future performance"

  • Report this Comment On May 16, 2011, at 6:15 PM, Wade32ru wrote:

    This write-up doesn't quite read correctly IMHO. You mention multiple compression as being the culprit for killing portfolio returns. This is like saying that someone got drunk because their blood-alcohol level was high. No, they got drunk because they drank alcohol, and their alcohol level is just a measure of that. Same with a multiple - its just a relative measure of a company's price, but it says nothing of the causality of the stock's current trading price.

    In short, a falling price will kill returns. The falling price will be reflected in a lower EBITDA or PE multiple. But its the price that's killing your returns, not the multiple compression.

    And how does multiple compression limit future returns? I could see how lower margins and lower sales growth can limit future returns, but multiples? Cart before the horse, dude.

  • Report this Comment On May 16, 2011, at 9:51 PM, BioBat wrote:

    A more appropriate title would be "Why you shouldn't invest blindly in blue chips".

    To say investing in blue chips (as a broad generalization) is ignorant at best and downright irresponsible at worst. Sure if you sunk $10K into Ford in 2001, you'd be feeling some pain right now, but if you had in March 2009, you'd be looking at a a $150K appreciation. As with everything, it's all about market timing and unfortunately, one of the best buying opportunities of a lifetime for many blue chips is already 2+ years gone.

  • Report this Comment On May 16, 2011, at 9:51 PM, jcamerin wrote:

    If you owned CAT today, would you sell it?

  • Report this Comment On May 16, 2011, at 10:36 PM, jesvlim wrote:

    Why are C, F and GM still categorised as blue chips in the first place? And what industry are they in at the miserable moment? KMB at 17.9% ebitda margin? I will take it with WAG anytime, especially these times. I mean what do you expect? Steady and stable blue chips that generate phenomenal growth? Please get real. Lower risk means lower returns, otherwise we are investing in ponzi schemes.

  • Report this Comment On May 16, 2011, at 11:31 PM, crca99 wrote:

    This is a warning we don't hear often enough. I've bought good companies, or so I thought, with growing fundamentals only to watch their price multiples compress. Medtronic, Walgreens, EMC, and Paychex come to mind.

  • Report this Comment On May 17, 2011, at 6:12 AM, Sunny7039 wrote:

    Maybe I am misunderstanding the article, and these comments as well. Do people buy "blue chips" to trade, or to hold? And when do you buy them, and which ones? (BioBat was right on target . . . Ford is, amazingly enough, a stock that you could have easily doubled your money with several times over the last 15 years or so, if you bought and sold at the right time. Few people realize this about Ford . . . but then, that's not why you buy a "blue chip." At least that's not what I thought.)

    I always thought blue chips were for that part of your stock portfolio that you planned to hold, subject to revision OF COURSE, and that you expected to generate dividend income with a yield greater than the rate of inflation, as well as appreciating over time at a rate ahead of inflation -- most of the time ahead of inflation, but in any case at least equal to the rate of inflation.

    Are people going to be traders with all of their stock holdings?

    If so, teach me how. I'd love to see a small retail investor consistently win at this game.

  • Report this Comment On May 17, 2011, at 6:14 AM, Sunny7039 wrote:

    pastreet -- yes, your last line! Great!

  • Report this Comment On May 17, 2011, at 8:06 AM, Fumaten wrote:

    Ford (F) made a 539% move last year from ~$2.39

    Timing this is the word

    http://iknowfirst.com/

  • Report this Comment On May 17, 2011, at 11:07 AM, ElCid16 wrote:

    People flock to blue chips during fluffy markets for value purposes. All of the companies you mentioned here were trading at historically high ratios in 2001. What if you invested in MCD or K? Those are big companies. It's not just about throwing random darts at large caps, its about selecting large caps.

  • Report this Comment On May 17, 2011, at 11:18 AM, sept2749 wrote:

    For my money dividend paying blue chips can provide a very nice income stream with varying degrees of capital appreciation. Granted the appreciation is going to be smaller then a small cap that starts to grow but you are aslo buying a degree of safety.

  • Report this Comment On May 17, 2011, at 12:59 PM, indiobravo wrote:

    Do your homework and look for big, sound companies paying a dividend over 3.5%, with a payout ratio below 80%, market cap to leverage free cash flow below 15, and a history of regular dividend growth. Make sure it isn't a damaged company or a damaged industry, and you can be confident of making a nice investment for a long term. Of course, diversification is always a key to success.

  • Report this Comment On May 17, 2011, at 1:59 PM, esxokm wrote:

    Great article, David. I myself have seen subpar returns from Disney, although the position is profitable because of dividend reinvestment and dollar-cost-averaging.

    Nevertheless, the point is well-taken: one wants to find stocks that will generally go up over time, not have a negative ten-year return. Whether or not dollar-cost-averaging helps out in the latter case, it still would have been nice to see a positive return over long periods.

    Question: does the above chart from Yahoo! Finance showing 10-year return stats for GE/etc. include dividend payments?

  • Report this Comment On May 18, 2011, at 12:17 PM, mikecart1 wrote:

    Funny how you articles are written in a way that extract the worst of the worst and ignore the best of the best. I find it funny how 100+ other blue stocks were not mentioned. Would MCD be considered a Blue Chip? Last time I checked the past 10 years has returned nearly 100%.

    Another bad article. No surprise.

  • Report this Comment On May 18, 2011, at 10:26 PM, critiquer wrote:

    Interesting article. Too bad some of the facts are bogus. The PE for WAG equals 19, the PE for EMC equals 30, not 8 and 15 as proposed in the article. Doesn't prove the author is wrong, but still.

  • Report this Comment On May 19, 2011, at 10:03 AM, puhls wrote:

    puhls

    Nonsense. One can find current or permanent dogs in every class and sector.

  • Report this Comment On May 20, 2011, at 5:58 PM, whyaduck1128 wrote:

    Hey kids!

    Can you say "cherry-picking data"?

    Sure you can.

  • Report this Comment On May 25, 2011, at 6:55 PM, Atr7865 wrote:

    Blue chips are well and good for those people who are working and do not have time to constantly keep an eye on their portfolio. I hve seen in the past that even if they fall they do not drop like a lead ball,but they fall more gradually,which works in the best intrest of the holder. Take the example of AiG. the bnkrupt company after taking a huge hand out from the Government,start to show some increment in price. But eventually start to slide after the glitter is gone.

    A. Razvi

  • Report this Comment On October 22, 2012, at 1:00 PM, NickD wrote:

    MCD NKE YUM CL./

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