Can You Really Make Money in Blue Chips?

My fellow Fool David Meier penned an article the other day titled "Why You Shouldn't Invest in Blue-Chip Stocks." In spite of the title, David noted that there are good opportunities among the large caps, but you have to be choosy.

The readers of David's article weren't so sure. The very first comment concluded that "I don't invest in any of the blue chip companies because they [sic] upside is very limited." Which makes sense, right? When we broadly say "blue chips" or "large caps," we're talking about massive companies like ExxonMobil (NYSE: XOM  ) , Apple (Nasdaq: AAPL  ) , and General Electric (NYSE: GE  ) -- the largest, best-known companies in the entire world.

How is it possible that investors would have overlooked an opportunity in these shares?

Follow me and let's find out.

Flow, flow, flow your funds
Fund flows refer to the amount of investor money that's either being newly invested in or pulled out of investment funds. Helpfully, the Investment Company Institute makes available data on mutual fund flows that gives us some insight into how investors are directing their money.

Year

Domestic Equity Funds

Foreign Equity Funds

Bond Funds

2007 ($74.6 billion) $138.3 billion $109.1 billion
2008 ($151.6 billion) ($82.7 billion) $27.7 billion
2009 ($39.5 billion) $30.7 billion $376 billion
2010 ($95.9 billion) $59.1 billion $230.1 billion
2011* $14.7 billion $23.2 billion $59.6 billion
Total since 2007 ($319.9 billion) $168.6 billion $790.2 billion

Source: Investment Company Institute.

Notice the hefty outflows from domestic equity funds versus the modest inflows for foreign funds and the massive inflows for bond funds. Good investment opportunities start to disappear as more money starts to chase the same investments. When money is running scared from an asset class though, there's a better chance of finding overlooked opportunities. Score one for domestic stocks.

Of course as my fellow Fool Morgan Housel pointed out last year, mutual fund flows don't tell the whole story anymore and we have to consider what's going on in exchange-traded funds.

Notably, $147.4 billion of new funds flowed into domestic equity ETFs between March 2010 and March of this year. But since ICI breaks down the ETF fund flows to a more granular level, we can dig in even further here.

Fund Type

Asset Growth 3/31/2010 to 3/31/2011

Total market 31.7%
Large cap 17.7%
Mid cap 31.4%
Small cap 30.8%
Commodities 50.6%
Natural resources 70.8%

Source: Investment Company Institute.

Despite the fact that there seems to be a lot of people talking about the opportunities in large-cap stocks, far fewer investors appear to be aggressively shoveling their money into that part of the market.

Ignoring success
To put it very simply, large caps have been performing over the past few years, and investors just don't seem to give a rat's patootie.

Just take a look at what happened between the most recent 12-month period and the corresponding 12-month period three years ago.

Index

Total Net Income Change

Starting Average Price-to-Earnings Ratio

Ending Average Price-to-Earnings Ratio

S&P mega caps* 19.3% 19.4 17.9
S&P 500 19.3% 23.5 24.5
S&P SmallCap 600 1.7% 24.7 27.0
S&P MidCap 400 (11.6%) 24.3 28.0

Source: Capital IQ, a Standard & Poor's company.
*S&P mega caps is an invention of the author and includes the largest 25 companies in the S&P 500.

The largest companies have larger profits and a lower price tag than they did three years ago. Yeah, that sounds awful.

Nothing new under the sun
Investors fall into and out of love with different asset classes. Sometimes they're absolutely in love with large caps (think "Nifty Fifty"), while at other times they're completely enamored with the growth opportunities available from small caps.

The chart below compares the five-year returns from the Russell 2000 small-cap index and the S&P 100 large-cap index. When the chart is above the horizontal axis, it means the small-cap index is outperforming the large cap, and when it dips below the axis the opposite is true.

As you can see, there was a period of small-cap outperformance in the early '90s, followed by a huge run by large caps that lasted through the dom-com bust and then led into the recent strong period for small caps.

What comes next? Turning data into patterns is a cognitive bias that we can fall into, but I'm going to go ahead and say that large caps look set to outrun the small fries.

Drumroll, please...
We started with this question: How is it possible that investors have overlooked a good investment opportunity in the world's largest and most successful companies?

Well, I'll tell you how. Investors have simply put their money elsewhere. They've run with the party line "large caps are too big to provide good returns," and they've plowed their money into small caps and mid caps thinking that the potential for more growth will trump all.

As a result, the three stocks noted in the beginning -- Exxon, Apple, and GE -- have respective forward price-to-earnings ratios of 9.1, 12.8, and 13.8. Yes, Apple has a forward P/E of 12.8. And they're not alone. Microsoft (Nasdaq: MSFT  ) trades at 9.2 times forward earnings, while Chevron (NYSE: CVX  ) and Pfizer (NYSE: PFE  ) have respective P/Es of 7.6 and 9.5.

Does this sound crazy? Maybe it does. But it's only because it sounds crazy to most people that these opportunities exist at all.

Rushing into buying anything is a bad idea, but the stocks that I've mentioned here are a good place to start your research into large cap stocks. Click on the "+" sign next to any of the tickers to add the stock to your watchlist. Don't have a watchlist yet? Click here to get started (it's free!).

The Motley Fool owns shares of Apple and Microsoft. Motley Fool newsletter services have recommended Pfizer, Chevron, Apple, and Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Motley Fool newsletter services have recommended creating a diagonal call position in Microsoft. Try any of our Foolish newsletter services free for 30 days. 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.

Fool contributor Matt Koppenheffer owns shares of Chevron and Microsoft, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (13) | Recommend This Article (22)

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 18, 2011, at 5:47 PM, Darwood11 wrote:

    Good Article!

    Disclaimer: I do invest in blue chips! About 25% of my "stock" portfolio is invested in blue chip companies with relatively low P/E and which also provide dividends. But not all of my individual stocks fall into that category. For example, NFLX.

    I am of the opinion that investing in individual stocks can be financially rewarding, and I have the personal evidence to support that statement.

    On the other hand, I also am invested in mutual funds, including large and small caps, bond funds, international bond funds, and even some commodities funds. Why? Because I cannot foretell the future. Or am I being foolish here?

  • Report this Comment On May 18, 2011, at 6:07 PM, TMFKopp wrote:

    @Darwood11

    "On the other hand, I also am invested in mutual funds, including large and small caps, bond funds, international bond funds, and even some commodities funds. Why? Because I cannot foretell the future. Or am I being foolish here?"

    Investing strategy can definitely differ from person to person thanks to differences in time horizon, personal risk tolerance, time available to monitor investments, etc.

    Spreading your bets and having balance in your portfolio can be a great idea. What you have to be careful of though is when certain segments of the market outperform, and those pieces of your portfolio take over a huge chunk of the overall portfolio. If your goal is for balance, you don't want a huge run in, say, small caps, to leave you with a massive position in richly-priced small caps.

    Personally, I try to maintain some amount of balance in my portfolio, but I try to allow myself to find where the value currently is rather than force myself to invest in particular asset classes. It just so happens that right now I have found a heck of a lot of value in large caps and quality dividend payers.

    Matt

  • Report this Comment On May 18, 2011, at 6:09 PM, energysystems wrote:

    It's all about timing. Back in July you could've picked up XOM in the 50s(or RDS in the 40s, which pays a significantly higher divi). Back when the Ipad debuted, the markets didn't like it and you could've scored APPL at around 200$. I do invest in large cap dividenders, but I buy when the p/e is below the avg market multiple(and atleast a few hundred basis points below, not just slightly lower), and I prefer companies with lower debt(the lower, the better). Blue chips have the $$$ to invest, and the $$$ to be very flexible in a choppy market.

  • Report this Comment On May 18, 2011, at 6:19 PM, bretco wrote:

    Great article, something that seems to be occurring less frequently with all the new

    (F)fools on board the Motley ship,

  • Report this Comment On May 18, 2011, at 6:27 PM, ChrisLynn1 wrote:

    Thanks for your thoughts about the blue chips. Very helpful.

  • Report this Comment On May 19, 2011, at 6:04 AM, Darwood11 wrote:

    @TMFKopp:

    Thanks Matt! I appreciate the input.

    I do agree with the "balance" thing, I'm definitely not a market timer and I nearly got burned a few years ago when it seems everyone, and that includes many fund managers, began chasing yield and loading up on financials. Personally, that's one of the issues I have discovered with actively managed funds; they sometimes have quite a lot of latitude in the prospectus, and even some companies can morph over time, e.g., GE became less industrial and more financial.

    To keep track of my fund holdings, I also use the MS X-Ray tool. this includes a combined portfolio of my spouse's and my investments, including cash.

    I do adjust my portfolio (re-balance) periodically to keep a "core" portfolio style. But if a stock is running I may let it go for a while (that does happen from time to time, e.g. NFLX).

    I also analyze my entire portfolio and use the X-Ray stock intersection tool to get a snapshot which I then use as an aid when attempting to determine if I should buy a particular stock. I attempt to purchase stocks which are not significant in the funds we own. I realize there is lag, and even a possibility of error in the X-Ray..

    I've kept my stable of individual stock at about 25. I've found that to be manageable. Add in our 401ks, which have some restrictions, and I think I have more than enough to manage.

  • Report this Comment On May 19, 2011, at 7:30 AM, rtichy wrote:

    I'm reading this article several hours after I read an article at SmartMoney (via Yahoo) called the "Invisible Stock Bubble", by Jack Hough. I think I'm more receptive to the argument in that article that earnings could/will plunge for the S&P 500 because the actions they took to bolster their bottom lines during the Great Recession and have continued are unsustainable. Either they need lots more labor for the long run, or the American consumer will fail on them and the topline will crash.

  • Report this Comment On May 19, 2011, at 7:41 AM, rtichy wrote:

    (continue from last post)

    I thought after I posted that my comments seemed too focused on the short term, and I want to further explain that. Not only do I think the short term doesn't look good for the S&P 500, but I don't think that investing in an asset class like "large caps" offers enough chance for growth if you use a mutual fund. Now if you feel like you want to diversify and are looking for foreign exposure, I can understand choosing large cap foreign stocks, because when you invest overseas you are also investing in a different regulatory environment that you are less familiar with, so stay with "safer" companies while getting exposure to overseas economies. But I still prefer individual companies to mutual funds.

  • Report this Comment On May 19, 2011, at 9:14 AM, ServusDei7 wrote:

    Forward P/E is foolish. Nobody can foresee the future. Average earnings over past 3 years is a bare minimum to even out the ups and downs in earning, especially for cyclical stocks like GE. Shiller would go even further and use average earnings over past 10 years to calculate P/E, which shows good predictive value for future performance: the lower the P/E, the higher the returns. But that requires using the correct P/E.

  • Report this Comment On May 19, 2011, at 10:58 AM, goldengems wrote:

    I love blue chips.

    Caterpillar--up nearly 500% over the "lost decade," albeit much of that increase occurred in recent years.

    3M and Conoco--up a quarter.

    Apple, Ford and Cisco--still waiting for the upturn.

    And others held in ETFs.

    The gift that keeps on giving: reinvest the dividends, and watch what compounding does.

  • Report this Comment On May 19, 2011, at 12:18 PM, dpnrj wrote:

    CVX is one of my best performing stocks. I've been holding for less than 2 years and have seen a 70% return. It is STILL cheap oil while oil is trading at $40 / barrel under its peak.

    Other than avoiding micro-caps, I don't spend too much time worrying about market cap. If the company is strong and looks to be strong in the future, I buy.

    Large caps have the benefit of having a moat that makes entry for smaller caps from taking their market share. These are the reasons why I'll continue to hold GOOG, AAPL and V. The market will catch up with their value, and my downside risk is low.

  • Report this Comment On May 24, 2011, at 5:36 PM, ElCid16 wrote:

    Great article.

  • Report this Comment On October 19, 2012, at 9:44 PM, NickD wrote:

    McDonald's and Yum Brands next 40 years China that is Blue Chips making alot of money for you.

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