How to Pick Blue Chip Stocks for Your Portfolio?
Blue Chip stocks are stocks of companies that are the pillars of an economy. These companies have a large market capitalization, stable earnings history, leaders in their domain, and promising growth prospects.
They are the foundation of the financial markets and are usually preferred by many mutual funds and seasoned investors. However, there are many blue-chip stocks, and choosing the right one can get overwhelming, especially for new investors.
Today, let’s understand how to pick blue chip stocks. And offer some suggestions to help in your selection.
Understanding Blue Chip Stocks
Think of blue-chip stocks as an exclusive club of stocks where only those stocks are permitted who are market leaders in their domains.
While there is no specific definition of Blue Chip stocks, here are some characteristics that define them:
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Large Companies
The first way to identify a blue-chip stock is by looking at its market capitalization. These are usually larger to very-large-cap stocks that are stock market giants in their sectors.
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Market Leaders
Blue Chip stocks are leaders in the market in their industry. Some of the best blue-chip stocks in India are Reliance Industries, Tata Consultancy Services, Hindustan Unilever Limited, Infosys Limited, HDFC Limited, etc.
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Steady Earnings History
It is important to remember that blue-chip companies take decades before they establish themselves as market leaders. Hence, they have a long history of stable earnings.
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Promising Growth Prospects
There are many types of companies in the market. While some companies manage to grow fast due to favourable market conditions, once they reach their peak, the growth prospects look bleak. However, blue-chip companies have promising growth prospects making them excellent investment options.
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How to Choose the Best Blue-chip Stocks for Your Portfolio?
Many investors try to invest in blue-chip stocks but struggle to differentiate between companies with large market capitalizations and blue chips. While the characteristics specified above can help you identify blue chips, here are some tips on how to pick the best blue chips for your portfolio:
1. Market Capitalization
Market capitalization is the total rupee value of a company’s outstanding shares. It is calculated by multiplying the total number of shares of a company by the current market price. It is an indicator of the size of the company.
The first step in choosing blue-chip stocks is finding large-caps that are leaders in their domain. Based on the composition of your portfolio and investment preferences, choose the sectors/industries that you would want to invest in and look for the best companies based on market capitalization.
2. Income of the Company
Apart from the market capitalization, look at the income/revenue of the company. Typically, companies with a bigger share in the industry will have higher revenues.
You can also compare the revenues of companies from a sector to find the top 5/10.
3. Compare the Piotroski Score (F-Score)
If you are new to stock analysis, then you are probably unaware of the Piotroski Score or F-Score.
The Piotroski Score is a predefined score to assess the financial strength of a company. It takes into consideration the following nine aspects of a company’s financial statements:
- Net Income
- Return on Assets (current year)
- Operating Cash Flow (current year)
- The quality of earnings (Operational Cash Flow > Net Income)
- Decreased Leverage (Long-term Debt Ratio in the current year < previous year)
- Increased Liquidity (Current Ratio in the current year > previous year)
- No Dilution (No new shares issued this year)
- Gross Margin of the current year > previous year
- Asset Turnover Ratio of the current year > previous year
The best F-Score is 9. A higher F-Score denotes a financially stronger company. Typically, a score of 6 or higher is considered to be good. Also, remember that if certain sectors are going through turbulent times, then the F-Score of most companies from the sector will be low. Compare accordingly.
4. Return on Equity (ROE)
Return on Equity or ROE is a financial ratio that can help you identify companies that have higher profitability compared to shareholder equity. Before comparing ROEs, it is important to remember that every sector/industry has different ranges of normal ROEs.
As compared to the peers, if a company has a higher ROE, then it is an indicator that the company is using shareholder equity efficiently (better than its peers) to generate profits. Also, ensure that you look at the ROE ratios of the last five years.
5. Return on Assets (ROA)
Return on Assets or ROA is one of the most common financial ratios used to identify a company that is using its assets efficiently to generate returns. It is calculated by determining how profitable a company is compared to its total assets.
Unlike ROE, it takes into account the company’s debt too. While profitability is essential in finding a good blue-chip stock, the efficiency of the management to optimize the resources of the company while ensuring profitability is the sign of a company that can weather various economic storms.
6. Valuation of the Company (Intrinsic Value of a stock)
Many investors consider the market capitalization of a company to be its market value. This is an incorrect approach because the market cap is based on the price you pay for the stock and NOT the value of the company. And the price of a stock depends on a range of factors, including the demand-supply, social, political, and other macroeconomic factors.
While looking for blue-chip stocks, most investors look for companies that are in the top five in a specific industry. However, just looking at the market capitalization can be counterproductive.
Remember, the market value of a company is its true worth.
Read more on Valuation of a Company
Let’s understand this with the help of an example:
Let’s say that the price of a new car is Rs.5 lakh. However, due to an increase in demand, it is being sold at Rs.10 lakh. If you purchase the car at Rs.10 lakh, then you are buying at available prices, but the car is not worth the money. On the other hand, if the car is not in demand, retailers might offer it at a discount for Rs.2.5 lakh. In this case, if you buy the car, then you get twice your money’s worth.
Similarly, if you buy a stock at a price that is more than what it is worth, then you have to bank upon the continual increase in the price of the stock to make profits. However, if you buy an undervalued stock, then the chances of making profits increase.
When you start looking for blue-chip stocks, ensure that you focus on the intrinsic value of the stock rather than its price. There are many tools that allow you to find the intrinsic value. Compare it across companies from the same sector to get a final list of blue chips that you want to invest in.
Take Away
Remember, a blue-chip stock usually comes with benefits, including consistent dividends, predictable growth trajectory, and lower volatility. These are considered relatively safer than other stocks.
However, you can benefit from them, provided you choose the right ones. Ensure that you focus on the valuation of the stock/company and avoid overvalued stocks. Also, align these investments with your investment plan.
Remember, these stocks are not usually fast-growing. Also, they carry the risks associated with other stocks. Hence, it is important to choose them wisely. While these are a few suggestions that should help you invest, your conviction is more important. Research and analyze thoroughly.
Happy Investing!
Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.