If you polled a group of investors as to which stock type they felt was the safest investment. the majority would likely reply, “blue chips.”
You might respond, “Hmm, interesting.” But you might be thinking, “What the heck are blue chip stocks?” Well I’m glad you asked.
In this article, I’ll go over what a blue chip stock is exactly and provide tips on how you can safely invest in them and maximize your return.
What Are Blue Chip Stocks?
In a poker chip set, the blue chips are typically worth the most. Which is why, in the stock market, high quality companies that are large and reliable are termed “blue chip stocks.” While these companies may not expand as rapidly on a percentage basis as new and emerging businesses, they usually have greater fiscal backing to weather bad economies and bear markets. Thus, they are viewed as safer investments than smaller growth stocks.
These market leaders often pay out a portion of retained earnings in the form of a cash dividend to shareholders. Why? One reason is that it attracts income investors looking for regular cash dispersions paid much like a bank does with interest. Another reason is that because blue chips are giant companies, there may be fewer opportunities to invest retained earnings in. Instead of sitting on a pile of cash, they can reward shareholders with dividends.
Is a High Yielding Dividend a Good Thing?
If a dividend is the amount of cash paid to shareholders, wouldn’t you want the biggest possible return? Absolutely! If you had the risk-free choice of choosing a 10 percent annual dividend versus a 3 percent return, the highest dividend yield would always be the better choice in earning passive income. But blue chip stocks that pay dividends are not risk-free despite being large and profitable companies.
When a company offers abnormally high dividend yield payouts, you need to ask yourself the following:
- Is this payout sustainable?
- What effect does their dividend strategy have on share prices?
- Am I interpreting the dividend yields correctly?
With these three points in mind, let’s review a few tips when it comes to income investing.
1. Make Sure the Company has Some Growth
To determine whether a company is growing you can look to the earnings per share (EPS) over a 5 or 10 year window – which is one of the main factors to consider when buying a stock. If total earnings have eroded over time, you should contemplate if the dividend is sustainable. If earnings are shrinking, then share price is likely to follow. Despite a company maintaining dividend yields, your income payout will shrink proportionately with a falling share price if earnings slide over a long period of time.
An increase in earnings should be backed by an increase in revenue. There are many ways to artificially inflate earnings over short periods of time such as share
buybacks, one-time special payments, or by increasing the percent of net profit. But unless revenues increase, the earnings growth may not be sustainable.
2. Do Not Analyze Trailing Dividend Yields
When looking for a high yielding dividend paying blue chip stock, make sure you are looking at future yields instead of trailing ones. Why?
A stock will sometimes pay out a one-time dividend that is very high. They may never do it again. If you compare the previous payout to the current share price, it may seem like the company returns exorbitant amounts to their shareholders. Imagine the disappointment of buying such a stock only to discover that they have no intention of paying out such dispersions of funds now or in the foreseeable future.
Trailing yields look very high when comparing historical payouts to dropping share prices. For example, company XYZ previously traded at $100 per share. They paid out $5 per share in an annual dividend which was a 5 percent yield. The company was then rocked by a scandal and share prices fell to $20 per share. By comparing a past dividend of $5 to the current price of $20, it would appear they pay out 25 percent yields. But if this wounded company chose to pay a dividend at all, it would likely maintain yields of 5 percent based on the current share price. Your disappointment will only be compounded by the danger of a falling share price if you look for high yields in all the wrong places.
3. Make Sure the Company Saves Some Retained Earnings
Some companies will pay 100% of their retained earnings out to shareholders. The percentage of earnings they pay is known as the payout ratio. A payout ratio of 100% may seem like a benefit, but it can be a double-edged sword.
When share prices rise faster than earnings (or the price-to-earnings ratio climbs), the company will need to increase the percentage of retained earnings they pay out in order to maintain yields. If they are already paying out 100% of the retained earnings, the company only has one of two options:
- Continue to payout 100% earnings while the yield drops
- Pay more than 100% by dipping into previous earnings
The first option will reduce the yield while the second will erode the intrinsic value of the company – not to mention that it is non-sustainable; nobody can pay out more than they earn for very long.
4. Find Big and Sustainable Dividends
One shortcut that I use to find fairly safe income stocks is by looking within the S&P 500 Dividend Aristocrats Index. Standard and Poor’s choose companies from the S&P 500 which is well-known for being leading companies in leading markets. To be included in the S&P 500 Dividend Aristocrats Index, the companies must have increased dividends every year for the last 25 years, be highly liquid, and have a large market capitalization.