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Why blue chips let you down

By Roger Montgomery

Why blue chips let you down

Are your returns stuck in a time warp? Are you surprised to hear Telstra’s share price is lower than it was in 1999? The NAB share price is also lower. That’s sixteen years with no price growth.

Rio and BHP’s share prices are lower than 11 years ago and Woolworths is lower than almost a decade ago. You might put it down to the resource cycle, disruption or poor management, but in each case I put it down to a poor definition of what a blue chip company is.

A portfolio of conventional blue chips will only ever provide investors with mediocre longterm returns. The arithmetic of poor returns is straightforward. Most large, high-dividend-yielding companies are mature and their earnings aren’t growing. Take Telstra for example; its first-half 2016 net profit after tax, EBITDA and earnings per share are the same as they were precisely 10 years earlier.

Separately, the profit achieved at BHP, now run by Andrew MacKenzie, is less than it was seven years ago and its shareholders have entrusted three times the equity it had back then and banks have lent it three times as much. If I gave you three times more money, you could put it in a bank and you’d earn three times as much interest without any effort and a lot less risk. Why would anyone take the risk of running or owning a business for a worse return than bank interest?

The boards of conventional blue chip companies have created another problem for investors. They have acquiesced to shareholder demands for more dividends and have increased their earnings payout ratios. As a result, they retain less profit for reinvestment and growth.

What’s more, because these major companies, such as the banks, Telstra, BHP and Rio, dominate the major ASX indices, you can say goodbye to high returns from index investing too. Australian retail investors have been putting their financial faith in conventional blue chip shares for decades. They’re described as stable, well known, pay steady dividends (until they suspend them) Most of them are mature businesses whose best years are behind them, with modest growth ROGER MONTGOMERY and they’re big — that is, they are usually found in the top 50 companies in Australia by market capitalisation.

But investor faith is misplaced and the low-return environment we have entered — which I wrote about in my last column on April 2 — will invalidate any perceptions of safety and long-run value creation from blue chips.

So if many of the companies to which the blue chip label has been attached aren’t really blue chip, what and where are they? I have a very specific definition of what a blue chip company is.

  1. It is a business that can retain large amounts of capital.
  2. It can generate high rates of return on that incremental capital. A business that can do this is like a bank account earning a 20 per cent interest rate and one which allows you to reinvest all the interest. 3. It is not exposed to external global dramas. A company where the equity grows at 20 per cent is like a bank account where the interest earnings grow at 20 per cent. If the bank account was listed, over time, and irrespective of what might happen in the wider world — a Brexit or troubles in Greece, the Middle East or China — the share price would grow by more than 20 per cent as its desirability gets recognised by the wider market. Build a portfolio of these businesses and you can’t help but do very well over the long run. Telstra, Woolworths, BHP, Rio, Santos, AMP, Lend Lease, Boral and Qantas are not businesses able to do this.

Of course their share prices may rise spectacularly and people might refer to them as blue chips but the bubble will always pop and you have to be very clever to time your entry or exit from these stocks. Instead seek out companies such as:

  • REA Group — the online real estate listing group (a subsidiary of News Corp, owner of The Australian).
  • Challenger Financial, the financial services group led by Brian Benari, which has specialised in annuities.
  • Isentia, the media intelligence and social media measurement group.
  • IPH, the intellectual property services group. The short-run influences of fear and varying popularity will ensure their share prices will wax and wane, but over time their true value should increase.
 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!