Having an investment strategy and sticking to it are the two main drivers for enduring success as an investor. Blue chip stocks may appear unglamorous and dull at first sight, but they are typically healthy, well managed companies with long track records of success and consistent returns. Read below how you can build a high performing blue chip stock portfolio by buying great businesses at fair prices to achieve excellent returns.
Why build a portfolio with blue chip stocks?
Blue chip stocks get their name from poker, where blue chips are often the ones with the highest value. In business, it refers to very large companies that are well-established, have an excellent reputation, are widely recognised and financially healthy. They are large, well-known organizations with a market capitalization in the billions that have been operating successfully for years if not decades. What makes them interesting for investment is that they have a history of dependable earnings and reliable growth. Well-known examples are Apple, Visa, Coca-Cola, Procter & Gamble or McDonalds.
Given their size and long history, these companies may not be as agile or disruptive as some new upstart. But that inertia provides us with something very valuable for long term investments: stability, dependability and lower risk. The question then becomes: How can we achieve high returns with such a seemingly safe bet?
For one, stable growth doesn’t automatically imply low growth. The prototypical blue chip companies mentioned above had an average annual return on assets between 9% and 20% during the last 10 years. In addition, many blue chip companies pay regular dividends to their shareholders. And finally, there are two sides to a business: its value and its price. In the long term, these are correlated so that high-quality businesses will command higher prices. But in the short term, even these huge companies aren’t immune to economic up and down swings or excessive market sentiment.
This is the core idea at the heart of our blue chips value investing strategy: Identify great businesses and purchase them at a fair price, i.e. when their market price is below their value. If our assessment about the value of the company is correct, the market will eventually recognize and correct the discrepancy. And this appreciation of the price to the fair value of the company provides us with the third driver of return. So how do we find out what a company is worth and whether its stock is cheap or expensive?
The strategy in a nutshell
Our strategy consists of six steps that act as a funnel to gradually filter down the market to the sparse but promising opportunities for buying great businesses at fair prices:
- Define a universe for investing, i.e. what is the range of stocks to consider for investment?
- Assess the health of a business by analyzing its financial statements and measuring performance of key financial metrics against a set of clear criteria that are indicative of superior businesses.
- Evaluate its competitive strength: Does the business undeniably outperform its closest competitors?
- Calculate the intrinsic value of the business, i.e. the present value of the expected future cash flows (absolute valuation) and compare it to its price.
- Use valuation with multiples (relative valuation) to compare the price of the stock to similar assets to enhance and reaffirm the absolute valuation.
- Study the annual reports to ensure that you fully understand the business, surface any substantial risks that weren’t obvious in the numbers, and complete the investment thesis with a clear and compelling narrative for the investment.
Let’s take a closer look at each of these steps.
The strategy step by step
Step 1: Define the stock universe for investing
Our investable universe defines the range of tradable assets that are in line with our investment objective. There are more than 50,000 publicly traded companies in the world, but a focus on blue chip stocks will reduce that number significantly. An obvious way to do that is to use the market capitalization of the company as a criterion and only consider companies that exceed a certain market value and are classified as large caps (more than $10bn) or even mega caps (more than $200bn). According to companiesmarketcap.com there are about 1,600 companies with a market capitalization greater than $10bn and only 55 companies with a market capitalization greater than $200bn in April 2024.
In addition, we can put constraints on geography or sector to further narrow down our investment universe. As an example, my personal universe is defined as follows:
- Companies from the US or Europe (Eurozone plus UK and Switzerland),
- with a market capitalization greater than $50bn,
- that are not banks or insurances.
That gives me a universe of approximately 250 companies to invest in.
An alternative starting point are blue chip indices such as the Dow Jones Global Titans 50 (which contains global blue chip companies but is very US centric) or the EURO STOXX 50.
Step 2: Assess the health of the business
In order to find great businesses at fair prices we first have to understand whether a business is in great shape. To do that, we analyze the three common financial statements of all publicly traded companies: the income statement, the balance sheet and the cash flow statement to answer a small and selected set of questions about its operations such as:
- Are the margins high and consistent?
- Is the income consistent and growing?
- Is the amount of debt the company has small compared to earnings and equity?
- Is the return on equity high?
The actual performance of a company gets scored against a set of predefined targets that have historically been indicative of outstanding businesses with an enduring competitive advantage. The data we need for this is freely available, e.g. on Yahoo finance, and using spreadsheet templates, the assessment can be done in as little as 5 minutes. I describe this process in detail and with illustrating examples in another article that can be found here. If the final score for a company is high enough, we can proceed with the next criterion – competitive strength.
Step 3: Evaluate competitive strength
When we make the filter from the previous step intentionally restrictive, the companies that pass it are very likely to enjoy a competitive advantage. But in the spirit of the old Russian proverb we want to “trust, but verify”. We can do that in three simple steps:
- Find a set of relevant competitors using Google or ChatGPT, or take it from the annual report of the company.
- Take a subset of the metrics we used in the previous step (e.g. gross margin, net margin and return on equity) and compare the performance of the competitors against the company we are assessing for investment.
- Count how often the company outperforms its competitors, e.g. it has the higher gross margin.
Companies that have a competitive advantage working in their favor will easily outperform their competitors in 60% to 80% of the metrics. If that is the case, we can move on to evaluate the other ingredient to “great businesses at fair prices” – its value and price.
Step 4: Calculate the intrinsic value of the business
“The intrinsic value of a business (or any investment security) is the present value of all expected future cash flows, discounted at the appropriate discount rate”, according to the Corporate Finance Institute. This is different from the market value of a company, which is reflected in its stock price. As value investors, we seek opportunities where companies are undervalued by the market, i.e. the intrinsic value is higher than the current stock price, usually by a significant margin of safety. There are several approaches for calculating intrinsic value and the most popular one is the discounted cash flow model. To do this, we need five ingredients:
- The current free cash flow of the business: This is usually taken as the average of the last three to five years.
- An estimate of how the cash flows will grow over time: This is the hardest part of it. We can rely on analyst estimates, or come up with our own growth estimate, e.g. based on how cash flow itself grew in the recent past or how other earnings related metrics have developed. The company itself will typically also announce growth targets to the markets against which it is then benchmarked by analysts.
- A time period for the valuation: We shouldn’t expect to be able to predict the future with great accuracy let alone the far future – we are only producing an estimate, an educated guess. Plus, even as long term investors our time horizon is ultimately finite. Thus, most models use a time horizon of 5 to 10 years (and there are some mathematical tricks to work with an infinite future should that be needed).
- The discount rate: 100 dollars today are worth more than 100 dollars a year from now. From this simple truth arises the need for discounting our estimates of future cash flows to get their net present value – what they are worth to us today – using one of many available methods.
- And finally the margin of safety: As mentioned before, we are not predicting but only estimating the future. That means our estimate may be off by a little – or a lot in some cases. In order to account for that uncertainty, we will only want to make an investment if the current price is safely below our estimated intrinsic value, e.g. 30% less.
The equations to do this can look a bit intimidating at first. But once we have coded them into a spreadsheet we can plug in our input data and get a clear result that tells us whether the company in question is selling at an attractive price relative to its intrinsic value or not.
Step 5: Relative valuation using multiples
In contrast to the previous step, we are now looking at how cheap (or expensive) a company is compared to its peers, i.e. its competitors and other companies from the same sector. This is usually done using financial metrics such as the P/E ratio (price to earnings) or EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization). Comparing the value for the company we are analyzing to the median of the comparison companies, gives us an impression of how the market currently prices the company and if it is a bargain or trading at a premium. It also serves to challenge or re-affirm the result of our intrinsic valuation, i.e. does the company appear similarly (under-) valued using both approaches? Added bonus: Using a little extra math, we can get auxiliary estimates of future value for the stock directly from the multiples we are using for the relative valuation: Using the earnings per share and multiplying it with the P/E ratio of the stock will give us its current price. Plugging in the median P/E of the comparison group instead, gives us an expectation of where the price is headed if the market corrects the current deviation.
Step 6: Study the annual report
Yes, you want to do this step last. Why? Because it is the most time consuming part and the least structured, but it is necessary. So you want to do that only for the handful of stocks that passed all the previous filters rather than for all of them. Remember, the goal is not to study the annual reports to find investment opportunities, but rather to complement the quantitative analysis with qualitative insights about the business to get the full picture and a compelling investment thesis. Even if the numbers look good on paper, once you put your money down, you also want to feel good – i.e. confident – about the investment you are making. And this comes from answering a few questions like these:
- Do I understand the business? (And could I explain it to an eight year old?)
- What gives the company its competitive advantage (“moat”)? Will they be able to sustain it or are there changes in the market or the regulatory environment that could diminish it?
- Do management’s opinion on the shape of the business and their outlook match our quantitative analysis results?
- In case we found any anomalies in the numbers: Are they explained well in the report?
- Can I create a convincing narrative as to why this stock is a good investment right now?
Roundup
These are the six steps of the strategy for building a portfolio of blue chip stocks by buying great businesses at fair prices:
- Define the stock universe
- Assess the health of the business
- Evaluate its competitive strength
- Calculate its intrinsic value
- Perform a relative valuation
- Study the annual report
Individually, each of the steps is relatively simple and based on facts and principles that have stood the test of time. But the real power comes from chaining them into an analysis funnel where companies that are candidates for investment have to pass each stage in order to warrant the effort for deeper analysis. Obviously, that saves a lot of time compared to doing a full analysis on each company and it focuses our time and attention on the increasingly promising opportunities.
There is also a natural cadence for when or how often to conduct or update any of the stages of the analysis:
- We define the universe of stocks for investing only once at the very beginning.
- Assessing the health of the company and its competitive strength needs to be done only once a year when the new balance sheet is published at the end of a company’s business year.
- Intrinsic valuation can be done at most once per quarter after a company has published its quarterly financial statements (so that we have the most recent cash flow data available).
- While the prices of stocks are constantly changing, the price to value ratio (aka the margin of safety) only needs to be updated at a much slower pace. Monthly updates are more than sufficient to keep track of general trends or sudden shifts, e.g. due to surprising results during a company’s quarterly earnings call.
- In theory, the relative valuation could change every minute together with the price of a stock. However, the multiples that are used rely on other financial metrics – such as earnings – that are only updated quarterly. Thus, the basic update cadence follows that of the intrinsic valuation (quarterly) and warrants an additional out-of-cadence update only when the price to value ratio suddenly makes a stock attractive to buy.
- Finally, the study of the annual report only needs to be done once and that is when a stock has successfully passed all the previous stages and it is time to form a final verdict about the company as an investment opportunity.
Last but not least, and maybe most important for individual retail investors: All of this can be done with information that is freely available on the internet: Websites like Yahoo finance aggregate and provide most of the financial data and the annual reports are usually available from the investor relations section of a company’s website.