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:

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:

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:

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.