Warren Buffett has said that it is okay to pay a fair price for a good company. Here are the blue-chips. But do avoid overpaying for them
23-Aug-2010 •Research Desk
These are the most prized stocks of all. They are most extensively researched, most talked about stocks in the markets. It is their movements that determine where the market is headed. Identifying blue chips is not a difficult job; the more difficult part is to know at what price to buy and sell them.
Most of the criteria we have used here are meant to identify blue-chips. The only criterion we have used to assess these stocks' valuation is the price-earnings to growth ratio. When you decide to buy blue-chip stocks, you could perhaps use other, more extensive, valuation criteria as well.
The advantage in buying blue-chips is that these stocks are already well researched, so information about them is easily available. You do not have to spend too much time digging for information. The underlying companies behind blue-chip stocks are generally large and well-established companies that offer scope for steady but significant long-term growth for years.
These stocks are ideal for buy-and-hold type investors. Their disadvantage is that since they are already quite large in size, they may not be able to give you the extraordinary returns that many stock investors seek. If chosen well, they will increase your wealth, but in a steady, consistent fashion.
From BSE 500 companies we selected companies using the following variables: market capitalisation, earnings per share, debt-equity ratio, interest coverage ratio, return on net worth, and price-earnings to growth ratio.
Market capitalisation. We considered only those companies that compromise the top 90 per cent of the market's capitalisation, i.e., large and mid-cap companies.
Earnings per share. Earnings per share is a measure of a company's profitability. It is derived by dividing profit after tax of the company with the total number of outstanding shares. To ensure that we only choose companies that have an excellent track record, we selected only those that have a compounded annual EPS growth rate of at least 20 per cent over the past five years.
Debt-equity. Even though the word "blue chip" has come from gambling where blue-coloured chips carry the highest value, we would not like the companies that we invest in to carry an unduly high level of risk.
Excess debt is a risk that should be avoided while investing. Hence we would like our blue-chips to have a debt-to-equity ratio of less than two.
Interest coverage ratio. This is another measure which can also give a sense of a company's leverage. It is the ratio of operating profits to interest expenses. It gives us a sense of margin of safety: the higher the operating profits of the company compared to interest expenses, the safer the company is from the risk of default. We would like to have companies in the list which have an interest coverage ratio of two or more .
Return on net worth. It is profit after tax expressed as a percentage of the total net worth of the company. Here we have not only kept a minimum bar for return on net worth but have also eliminated companies that have displayed too much fluctuations in return on net worth which might affect the average.
We chose companies which over the past five years have clocked an average return on net worth of 20 per cent or more (excluding companies with abnormal fluctuations in return on net worth).
Price-earnings to growth (PEG). This is defined as the ratio of price-earnings ratio of a company to earnings per share growth rate (here we have used the three-year historic growth rate). This essentially indicates the price you are paying for the growth rate you get to purchase.
If the ratio is less than one then the stock is trading at a discount to its growth rate, but if it is more than one then it is trading at a premium. In this case, we have chosen companies with a price-earnings to growth ratio of less than 1.5.
What we got
On applying these screens we got 26 companies altogether. Many of them are market leaders within their industries like Asian Paints, Maruti, Castrol and Exide. There are as many as four pharma companies - Piramal Healthcare, Torrent Pharmaceuticals, Ipca Laboratories and Lupin - in this selection.