Blue Chip companies. They are the financially strong companies the world does business with everyday. In several of our articles in the past year we have discussed the possible reasons why the investment performance of Blue Chip companies has lagged some other stock types when their underlying fundamentals -namely earnings--have done so well. Recognizing this in 2006, BusinessWeek carried a cover story about the huge divergence between the strong earnings growth of Blue Chips versus their meager stock price performance. Most likely, a large part of the explanation comes down to the most basic economic principle of supply and demand. While the supply of Blue Chips stocks has actually fallen due to corporate buybacks (discussed below) demand has fallen even more as investors have funneled capital into other less traditional, and often more speculative market areas (see chart). As we write this article, events taking place in the global markets suggest that changes may be in the works.
Institutional investors have been pouring record amounts of money into hedge funds and private equity styles that embrace small- and mid-cap securities. We're talking large sums of money: just last year private equity raised a record $404 billion, according to Private Equity Intelligence. At the same time, retail investors have gone wild for international stocks. The Investment Company Institute reports a remarkable 92% of all US equity fund inflows ($149 billion) went into international equities in 2006! The message is clear: demand for Blue Chip stocks is down, while demand for other asset classes is up, creating an opportunity for long-term investors. (Remember: buy low and sell high?).
Because of institutional and retail neglect, Blue Chip companies are experiencing a phenomenon that we have not seen in a long time: the combination of strong profits, record amounts of cash, and low valuations. Fortunately most of financially strong Blue Chip companies are taking advantage of this situation and buying back tons of stock which is building tremendous shareholder value.
Exxon Mobil saw earnings decrease by 5% in the fourth quarter but because of massive buy-backs earnings per share actual increased by 2%. BHP Billiton just announced a $10 billion buy-back which is equivalent to 9% of its market capitalization. Exxon trades for just 12x earnings while BHP is valued at a mere 10x earnings. Many other Blue Chip companies have reduced shares outstanding between 4%-9% since the bull market started, including Emerson, Aflac, Coca-Cola, Citigroup, ADP, Wal-Mart, Pepsi, American Express, and Colgate-Palmolive. Best of all, these companies are trading at their lowest earnings multiple in a decade. As an example, Pepsi's P/E valuation has fallen from 37 times to less than 20 times expected 2007 earnings while its shares outstanding has fallen from 1.7 Billion to 1.6 Billion shares since 2002. Clearly, Blue Chips offer a great value in today's market.
To this point asset flows have favored small-, mid-cap, and international stocks as we discussed above, but there are signs a transition may be afoot. Actions in the markets in the past week exhibit the high volatility that is present in speculative assets. For example, recently popular emerging market investments swooned on February 27th and again on March 1st. An actively traded emerging market ETF (exchange traded fund) that invests in emerging markets fell over 8% on the 27th.
The move to Blue Chips will likely occur when risk premiums in the market are on the rise. Risk in our economy is linked to and dependent on actions in the housing and finance sectors. We have written extensively about the dangers in the sub-prime mortgage market. This business has been melting down: several firms have recently filed for bankruptcy protection, the stocks of several large sub-prime mortgage companies have fallen more than 40%, and the sub-prime divisions of large integrated banks are in disarray. If the damage from the sub-prime mortgage business spreads into other areas of our economy, risk premiums will likely rise across all asset classes and investors may seek shelter in neglected Blue Chip stocks.
Bottom Line: Conservative investors have traditionally taken comfort in the consistent growth of Blue Chip stocks but today get the added benefit of low valuation.
James G. Tillar, CFA
To read more visit Tillar-Wenstrup Advisors on the web: www.twadvisors.com or send them an email at: info@twadvisors.com
Tillar-Wenstrup Advisors, LLC, may have ownership in stocks mentioned in the article above. There can be no guarantee of investment success made by Tillar-Wenstrup Advisors, LLC relative to these selections.
About the Author
James Tillar is a Principal with Tillar-Wenstrup Advisors, LLC, a registered investment advisor located in Dayton, Ohio.
