The new blue-chip shares

Investors’ favourite Aussie blue-chip companies are having trouble living up to their name

Blue-chip stocks have long been viewed as a sure bet for investors wanting to play it safe in the sharemarket. But as the economic impacts of Covid-19 reverberate through global sharemarkets, do blue chips still qualify as a safe investment? For a label that’s bandied about as much as any other in the investing world, “blue chip” is without a common definition. As Jamie Nicol, chief investment officer and director at DNR Capital, points out, “the definition of ‘blue chip’ can be in the eye of the beholder”.

The term is derived from the game of poker, where the blue chips are traditionally the most valuable. For investors, it usually means companies that are best in class.

“The term in investment parlance conjures up characteristics such as being a market leader, immune to economic cycles, financially secure with a long track record of success,” says Max Cappetta, chief executive at Redpoint Investment Management.

Jun Bei Liu, portfolio manager at Tribeca Investment Partners, believes blue-chip stocks exhibit enduring business models and competitive advantages. “Their earnings growth will be supported by structural and cyclical drivers, and will be run by an astute management team with a consistent track record in execution and delivering strong cash flows,” she says.

But the Australian definition of a blue-chip company goes a step further, with added importance given to a company’s brand heritage.

Hamish Tadgell, portfolio manager at SG Hiscock, says the Australian notion of a blue-chip stock draws undue attention away from the more important features that should define them.

“Personally, I don’t like the ‘blue chip’ label as it invokes familiarity or reference to well-known household names, rather than necessarily focusing on the attributes and quality of the business,” he says. “The issue in Australia is that the top 20 largest listed ASX companies has been relatively entrenched, which is in large part a function of the fact we are a relatively small service-based economy.”

By comparison, in the US, the largest blue-chip companies that make up the index have been much more dynamic and have been driven by innovation and entrepreneurship.

“The strength of a companies’ competitive position, earnings power and management, and sustainability of these things, is what determines its leadership position, and ultimately whether it should be considered a blue chip,” says Tadgell.

Welcome to the new normal

The coronavirus has introduced, at least for now, a “new normal” characterised by volatility and diminished returns, and blue-chip stocks aren’t immune.

“The Covid-19 pandemic has thrown a massive spanner into the normal functioning of the global economy in ways which we could not have imagined just a few months ago,” says Cappetta. “We are being presented with a very different economic shock at this time, the likes of which has not been seen in generations.”

But has it changed what a blue chip is or what it offers investors?

For Jamie Nicol, the answer is no. Rather, it’s exposed companies that claim, yet fail to satisfy, the features necessary to be considered blue chip. “You get a clearer understanding of a company’s competitive dynamics, earnings and balance sheet strength through times of market stress,” he says.

“The greater impact on blue-chip companies in recent years has been the lowering of interest rates and the increased advent of technology. Investors have gravitated to companies with earnings or dividend certainty, such as CSL and Woolworths, or those with a more reliable growth outlook such as Xero.”

Meanwhile, technology-driven businesses are undercutting many of these business models, offering tailored services at lower prices and cutting fat profit margins built over many decades. “Within the banking sector, they face a combination of regulation, higher unemployment, a weaker property market and cuts to net interest margins as interest rates settle near 0%,” says Nicol.

Now we’re seeing heavy discounts on blue-chips stocks. “Over the last month we’ve effectively seen some of the best blue chips go on sale,” says Dermot Ryan, Australian equities portfolio manager at AMP Capital. “For bargain hunters, the market plunge has opened up stocks that would otherwise be too expensive.”

This includes traditional defensive stocks and those that benefit from people staying home to maintain social distancing.

“We are favouring investing in essential services, supermarkets, infrastructure, packaging and hospitals and aged care,” says Ryan. “We expect telecommunications and service providers also to do well from the downturn as households increase their mobile and broadband packages and carriers start their 5G capex spending.”

Dividend debate

Australia’s love for blue-chip stocks dovetails its love for dividends – fully franked if possible. Not surprisingly, Covid-19’s impact on company revenue has seen many dividends slashed.

However, experts are split over whether dividends are a healthy feature of the market, be it now or during normal market conditions.

“Dividends are the outcome, they’re not the process,” says Paul Taylor, a portfolio manager at Fidelity. “They come at the end of the day – the stability of the company and earnings lead to dividends.” Taylor hits back at the argument that Australian companies are at a disadvantage because they pay out dividends, rather than re-invest earnings into the company. “Companies that pay higher dividends generally outgrow companies that pay low dividends,” he says. This is because the distribution of dividends leads to greater capital discipline.

“Because a company only has a limited amount to invest after distributing dividends, they make sure they generate a high rate of return on their invested capital,” he says. “On the other side, companies that pay out no dividends and reinvest typically generate a low return on investor capital, so the money is burning a hole in their pocket.”

Taylor also disagrees that paying out dividends prevents capital expenditure or acquisitions. Rather, it means companies go to investors and ask for the money. “Just because companies pay out high dividends, it doesn’t mean that they can’t come back to the market and do acquisitions and capex. But they have to justify to investors why they want the money.”

Kanish Chugh, co-head of sales at ETF Securities, agrees that capital discipline can be the result of high dividend payout ratios, but he adds an important caveat. “From a company perspective, high dividends promote capital growth, but what if they’re borrowing to pay dividends,” he says. “At the end of the day, that puts them in a worse position. Investors should view that as a net loss.”

The term blue-chip share is associated with high dividendpaying, oldfashioned businesses

Chugh also proposes that income investors broaden their view about the way income is generated.

“Rather than hang onto hope that dividends bounce back, investors might have to instead look at investing in growth companies, which they can then sell to earn income from the capital appreciation,” he says.

The investment case

So what does a blue-chip stock look like in a postCovid-19 world?

Drew Meredith, director and financial adviser at Wattle Partners, believes the days of relying on the most wellknown names and biggest businesses are gone. “The age of the internet has seen barriers to entry erased and sent many a blue chip to the brink of bankruptcy.”.

In his view, the “new” blue chips should be global businesses. They should embrace technology, invest in themselves rather than pay dividends and be constantly growing revenue and cash flow rather than relying on debt or equity.

Cappetta adds that having a perspective on how companies manage their risks in terms of their environmental impact, social connection and governance (ESG) practices can help identify good-quality businesses that are being well managed for the long term.

“Combining this with rigorous analysis of the company’s financial statements can provide new insights towards making better investments for the long term,” he says.

The case for blue-chip stocks now may be much the same as it was previously. The only difference is that the pandemic has exposed the emperors lacking any clothes.

“Unfortunately, the term blue-chip share in Australia has long been associated with high-dividend-paying, old-fashioned businesses, like our big four banks,” says Meredith.

“If the GFC wasn’t enough of a lesson, the Covid-19 shutdown has reiterated that these ‘blue chips’ are anything but.”

Case in point: Australia’s top 20 businesses include two grocery stores, four banks, two mining companies and one healthcare business.

“Only one of those businesses is trading at or near its all-time high and has a record of increasing dividends almost every year, excluding the GFC. The others are cyclical, highly leveraged or prone to cut-price competition,” he says.

“These businesses may well recover strongly, but they are not the sure things they have been perceived to be for so long. There is simply too much competition and they have generally become slow-moving, hamstrung businesses in need of more capital.”

On the other hand, Covid-19 could be providing impetus for blue-chip companies to cut the fat and develop more modern and efficient ways of doing business.

“The huge impacts that Covid-19 is having on businesses and individuals is seeing much needed assessments take place and will likely see important decisions being made,” says Meredith. “To once again become blue chips these companies need to become more nimble, more efficient, reduce capital expenditure and unfortunately improve productivity by embracing technology, regardless of any teething issues.”

Investors might have to look at investing in growth companies