Can blue chip companies keep growing indefinitely?

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After working with a technology company for two years, he wanted to start investing. Not knowing where to start, he sought advice.

Someone suggested that he invest in blue chip companies listed on the stock exchange.

The reason behind this was…

• Blue chip companies would always experience long term growth regardless of market cycles and therefore his investment will be safe in these companies.

He also wouldn’t have to worry about reviewing his stock portfolio often.

It didn’t surprise me.

Most new investors have these strange expectations, which are usually far from reality and often misleading.

But before we explain why, let’s find out what exactly a top-notch company is.

The term bluechip comes from the game of poker, where blue chips have the highest value.

In the stock market, this is also true. Of all the publicly traded companies, blue chip companies are the most valuable.

They have strong and reliable track records while providing long-term capital growth and constant dividends. Moreover, they are not very volatile. This reduces the risk of loss.

So does that mean bluechips are a safe investment?

No, these features do not guarantee safety.

They simply imply that blue chip companies are safer than their smaller and volatile exchange traded counterparts (midcaps and smallcaps).

Moreover, none of these characteristics guarantees that a top-notch company will grow forever.

Fool’s gold or real gold?

The best blue chip companies change every few years.

Companies that traded at the top in 2000 or 2005 or any other year are not trading at the top today.

In fact, several blue chip companies of yesteryear have wreaked havoc on the wealth of millions of investors.

They too were at one time nationally recognized, well established and financially sound.

A top notch company that comes to mind is Bharat Heavy Electricals Limited (BHEL).

Owned by the Indian government, BHEL is a manufacturer of power generation equipment.

The company in 2009 had a monopoly in the electrical equipment sector. However, it then succumbed to competition from private players and difficulties in the electricity sector.

This drove the stock price down. The company’s share price fell nearly 50% over the next two years, causing investors to lose a truckload of their wealth.

BHEL share price since listing

Source of data: Ace Equity

What about Satyam IT services?

The company was also a blue chip company that many investors lost money on.

An investigation had revealed that the founder, Ramalinga Raju, had fabricated revenues, margins and cash balances to the tune of approximately 70 billion.

The stock price plummeted, sending shockwaves through the industry, forcing regulators to implement tougher guidelines to protect investors.

The Rise and Fall of Satyam Computers

Source of data: Ace Equity

These are just some of the top notch companies in India that didn’t even last a decade. But if you were to cast a wider net, you’ll find several others across the country and the world who have met the same fate.

Who would have imagined that Lehman Brothers, a 170-year-old financial giant, would file for bankruptcy or that General Electric might be one of the worst performing stocks in the market?

These blue-chip companies went bankrupt, taking with them investors’ hard-earned savings.

Not an ideal world

But what if you had to leave before these blue chip companies collapsed?

Isn’t it time to put active investing to good use?

Some investors will say that they can foresee such problems/events and get out of the stock after a nice profit. But this is an error, an unrealistic assumption, called hindsight bias.

What is hindsight bias?

A hindsight bias is a psychological phenomenon that allows people to convince themselves after an event that they had accurately predicted it before it happened.

This can lead people to conclude that they can accurately predict other events.

Most investors (novice and expert) have in the past and will continue to miss such incidents. They would remain either ignorant or ignorant. The sheer size of these companies with their impeccable track records can blind anyone to any uncertainty.

Think about it. Who could have imagined the fall of the Lehman brothers or Zee TV?

Nothing lasts eternally

If we expect a blue chip company or any other company to grow forever, we say a company can outrun an economy forever.

How is it possible?

Think about it from an economic point of view. Continued strong growth will always attract competition, leading to lower profitability, loss of market share, or worse, both.

Consider these blue chip companies in international (developed world) markets (Colgate, Unilever, Nestlé, etc.).

Current P/E (BSE India)

Current P/E (international markets)

Colgate

36.6x

26.3x

Unilever

62.3x

24.2x

Nestle

75.5x

45.8x

Maruti

79.8x

12.9x

Siemens

75.5x

22.3x

Data source: BSE and Google Finance

Notice how they tend to trade at deeper discounts compared to their peers in the developing world. Now, that’s not unusual.

As economies develop, the growth rate of the companies within them begins to slow, consequently affecting their valuation multiples.

We can therefore say with the utmost certainty that the blue chips cannot grow indefinitely at a rate greater than that of the economy.

In conclusion

What should investors do? Should they invest in blue chips?

Although the last decade has been amazing for most of these blue-chips (Hindustan Unilever, Nestlé, HDFC Bank, Asian Paints, etc.), assuming they will continue to grow forever, it is wrong to provide returns stellar.

But buying companies passively, holding onto them forever, hoping they will perform well is also a mistake.

A better approach is to identify good companies that have the potential to grow over the long term. Base your decision on thorough research and your risk-return appetite, not just a stock’s price history.

Build a core portfolio with fundamentally strong and profitable companies that are market leaders and develop a balance between blue chip companies and other companies.

If you only stick to blue chip companies, chances are you will miss the next up-and-coming Tata Consultancy Services or Hindustan Unilever.

Keep in mind that investing in stocks comes with some inherent risks. Taking these steps will not eliminate the risks, but will surely minimize them.

Good investment!

Warning: This article is for information only. This is not a stock recommendation and should not be treated as such.

This article is syndicated from equitymaster.com

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