This article was published in Money Management 12 April 2018 issue
Not all blue chip stocks are the same. I outline a different way to think about long term blue chip investing.
Not all blue chip stocks are the same
Blue chip stocks are considered safe investments because they are the largest and most recognised companies in the world. In most cases large companies will be safe investments, however size does not always guarantee safety. In some cases, blue chip companies can become complacent and subject to disruptive competitors which is why investors should be vigilant when investing in traditional blue chip stocks.
Companies that are already very large and have dominant market share need to use their competitive advantage wisely to maintain their market dominance. It is imperative they do not rest on their laurels. For the largest companies in the market, the risk of being surprised by incumbent competitors is much greater than the potential to gain more market share. In other words, blue chip stocks have limited upside but face greater downside risk.
There are many examples of market leaders being made redundant in the current age of digital disruption, but I draw my experience from an example that was played out over many decades. The example is of Eastman Kodak which, in its prime, was the iconic photography company in the world.
The lesson in the Eastman Kodak example is that even the bluest of blue chips are not immune to downfall. The downfall was not due to one discrete event, but was a series of misjudgements by management over several decades. As a long term investor, how do we differentiate between a solid blue chip company and one that will decline over the long term? I think the answer lies in identifying the three categories of blue chip stocks.
Blue chips: the Growers, the Status Quo and the Faders
At the turn of this century, General Electric (GE), Microsoft and Exxon Mobil were the 3 largest companies in the world. Investing in these companies would have generated reasonable returns (GE being the laggard of this group). Fast forward to today and only Microsoft remains in the largest 3 companies list. GE and Exxon Mobil, whilst still considered blue chip, have both fallen outside the top 10.
History tells us that in all likelihood, today’s blue chips will not remain there forever – the dominance of companies is temporary and only as good as their relevance to tomorrow’s customers. The constant evolution of the list of blue chip stocks is much like the rankings of tennis players.
I find 3 categories of blue chip companies that aptly describe their ongoing evolution:
The Status Quo
Most blue chip companies fit this category. These are large companies that will continue to have some form of relevance to its customers. They have established competitive advantages but are capped by a saturated market. The Status Quo will continue performing reasonably over the long term. Microsoft, Walmart, Johnson & Johnson, Nestle and Shell come to mind in this category.
These are blue chip companies that do not rest on their laurels. They continue to behave as a young company, spending a lot of money on innovation and reinvestment. These companies are already successful in their own right and are comfortable with new business ventures and their potential failure. This category covers a large group of companies that are usually slightly younger than the average blue chip. Nike, Tencent and Ping An Insurance Group fit within this category.
There are a minority of traditional blue chip companies that will become irrelevant over time. They may currently be the largest players in their industry, but historical success becomes their enemy. Size of the organisation inevitably slows down decision making processes and they become fixated on historical business lines. These dinosaurs will fade over time as they become sitting ducks for the Growers. In a few severe cases, they can even disappear into oblivion as we have seen with Nokia, Research In Motion (Blackberry) and Eastman Kodak.
But how does one tell if a company will be a Fader or just merely Status Quo?
Avoiding the Faders
Borrowing from Carl Jacobi’s quote “Invert, always invert”, I like to think about the problem in reverse. If we want to invest in great companies with blue chip qualities, then we should start by avoiding companies that are likely to be Faders. So what makes the perfect Fader?
Just like Eastman Kodak, these companies fail to constantly innovate before it’s too late. These blue chips prefer to pay out a large proportion of earnings as dividends, leaving very little for reinvestment. If they do reinvest, they make poor decisions regarding which segments to focus on. They are cash cows focused on yesterday’s businesses. Be wary of large corporates that have below-average levels of reinvestment and very high dividend payout ratios. Management is usually bureaucratic and have very little equity ownership in the business.
Whilst they may be the largest player in their industry now, Faders operate in industries that can be bypassed. For example, traditional print media companies are losing business to digital advertising. The more complex the business model, the greater the risk of being bypassed. Products or services which are not essential to humans will be irrelevant over the long term.
Investing in a company that is already the dominant market leader is risky – if you’re already at the top, there is only one way to go. Dominant companies have already reached maximum market penetration so the need to innovate new products is even greater. Investing in Motorola in 1994 at the peak of its dominance turned out to be a risky strategy as it was eventually outmanoeuvred by Nokia. Just as Nokia was the dominant leader in mobile phones in the 1990’s, it was usurped by the Blackberry which has now been surpassed by Apple and Samsung. For this reason I am wary about investing in Apple and Alphabet because they are the dominant forces in their industries. There are less risky alternative stocks that still offer the same blue chip qualities for an investor.
The sweet spot of blue chip investing
Investors should not take blue chip stocks for granted. As we have witnessed through history, investing in blue chip stocks does not guarantee safety. By systematically minimising each potential risk, an investor will naturally find themselves attracted to a certain type of company that maximises their chances of exceptional returns. These companies tend to be consistently expanding geographically or through new business lines, won’t have a generous dividend payout ratio and provide a service that will remain valued by society over generations. These companies are more likely to deliver on your blue chip investment objectives – steady, resilient and sustainable investment returns over the long run.
At the time of writing, Lumenary was not an investor in any of the stocks mentioned.