How blue-blooded are blue chip stocks? What happens when they lose their value? We analyse all this in this series
Blue-chip stocks, or blue chips, are the cream of any stock market. They are among the biggest and the best of the thousands of stocks available for trade. Under ordinary circumstances, most blue chips are as fine an investment as you can find; but what happens when they lose their value?
The US stock market of the 1960s saw the rise of a group of stocks called the Nifty Fifty. This motley group consisted of blue chips considered as 'one-decision' stocks - just buy and hold them forever. Their consistent earnings growth made them high-quality investments at any price. This group traded at extremely high price-to-earnings ratios, often more than 50 times. It included companies like McDonald's, IBM, Disney, Texas Instruments, Coca-Cola, Wal-Mart, Eastman-Kodak, Polaroid, General Electric, Gillette, Pfizer and P&G, among other starry names.
In 1972, the S&P 500 traded at 19 times. The Nifty Fifty, on average, commanded a P/E of 42x. Some of the most expensive names in it were Polaroid (P/E of 91x), McDonald's (86x), Walt Disney (82x) and Avon Products (65x).
The crash of 1973-74 ended the dream run of the Nifty Fifty, with many stocks losing significant part of their market capitalisation. It would take many years - in some instances more than a decade - for these stocks to eventually recover from their fall. Forbes columnist Martin Sosnoff described the scene best: "The Nifty Fifty were taken out and shot one by one."
Coming back to present times, a number of our own desi blue chips today trade at valuations not very different from those of Nifty Fifty stocks. A similar optimism appears to have gripped the markets today. Brokerages put out a buy call on Hindustan Unilever, even at 52 times forward earnings, with fancy taglines such as 'Dominance + Growth = Priceless'.
These are dangerous times. Throwing caution to the wind can come back to hit hard later. Note that we do not question the quality of many of the expensive blue chips. In most cases, they are impeccable. It is the valuations they trade at that make them not-so-great investments today. At a lower valuation, absolutely load them up. Also, keep in mind that many of these blue chips could continue to trade at high valuations with the markets hitting record highs but earnings will one day come knocking.
We don't want to create a panic among our readers. We just want to remind investors that the price you pay for a stock is a strong determinant of your returns. Buying a stock at any price is not prudent investing, no matter how good a stock is. Wait for valuations to cool down in these expensive blue chips before putting your money in them.
Before moving on to read about a select group of blue chips priced perfectly, go back and re-read the second paragraph above and ask yourself: does it describe only the American Nifty Fifty of the 1960s or Indian blue chips of today as well?
We are running a week long series to give you a comprehensive idea about these stocks.