NEW YORK (MONEY Magazine) - Anyone who's ever whiled away an evening playing Texas hold 'em has at one point asked himself the same question that's troubling investors in these turbulent times: Where have all the blue chips gone?
In fact, the use of "blue chip" to indicate well-established, financially sound companies began at the start of the 20th century and came from poker, because blue was the color of the highest-denomination chips.
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The connection to poker is ironic, because blue-chip stocks were supposed to be antithetical to gambling. Traditional blue-chip companies were the patricians of the investment community -- conservative, sensible and forthright.
While they may have lacked the dynamic potential of their smaller, nimbler brethren, they compensated with reliable growth, regular dividend payments, rock-solid balance sheets and outstanding management.
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Along with every other old rule, those about blue chips have been turned around by the most turbulent market in decades. Witness how a sleepy manufacturer of well-known household goods can drop 30 percent in a single day, as Procter & Gamble did in the spring of 2000. And a high-tech company whose name is so synonymous with explosive growth that future stars are described as the next Microsoft is actually one of the most reliable generators of earnings.
In times of uncertainty, and with a record chunk of Americans due to retire, the need for the safety, reliability and stability of the blue chips of yore is more compelling than ever.
With that in mind, what are today's blue-chip companies? Are there any left? What distinguishes a blue-chip company and what can we expect if we invest in one? As Nick Lowe put it: Where are the strong, and who are the trusted?
Blue chips must be both stronger and safer than other companies -- that's where it all starts. So to be labeled blue chip, a company has to have a solid business franchise and a sterling balance sheet.
Blue chips must also have opportunities to expand their business. Plus, a blue chip should have a generous dividend payout or should be using its cash to buy back shares or pay off debt. And blue chips should have a minimum of volatility relative to the stock market as a whole.
The growth trap
In today's definition of blue chips, you need to overcome many biases. For instance, following two decades of mostly favorable markets, investors are conditioned to look for growth stocks. Growth is not irrelevant, but it is overrated -- mainly because investors pay dearly for that growth during a company's salad days. Unfortunately, in bad times, that premium evaporates.
Look at Cisco Systems. For a short time it was bestowed blue-chip status because it was the most valuable public company on the basis of market capitalization. From 1997 to 2000, Cisco grew at warp speed, and even at a price-to-earnings multiple of 196, there were investors and analysts rushing to praise the company's prospects.
Even though Cisco has actually weathered the collapse of its main markets fairly well and has remained profitable, its stock has lost 85 percent of its value as investors who got in looking for hyper-growth bailed out in droves.
In contrast to Cisco, there's Dell Computer. Between 1997 and 1998, Dell's stock rose 1,110 percent and traded for 82 times earnings. When the market decided that the big-growth days of the PC market had ended, Dell's stock was sliced in half between 1999 and early 2001.
But look what's happened since. Dell has seized the No. 1 position in the profitable but slowing personal-computer market. It has used its superior business model -- building to order and streamlined distribution -- to trounce competitors.
So far this year, while Cisco has fallen 17 percent, Dell stock has actually climbed 6 percent. Shares of Dell-the-growth-company would plummet in this stock market, as Cisco has. But Dell-the-stable-company has maintained its stock price throughout some very difficult conditions.
That doesn't mean you should shun growth when hunting for blue chips. If you ignore growth, you might as well buy bonds. But growth prospects must not drive the decision.
The dividend myth
Among companies with growth credentials, the outstanding candidates are those offering the most safety and stability. A traditional indicator of a company's stability has been dividend yield.
Dividends provide a cash return and thus a measure of safety. But don't fall in love with them, because dividends can never be more attractive than a company's prospects. Think of the dividend as part of a company's diversification of capital. Is the company really making money? If so, what is it doing with it? How much is going to investors in dividends or stock buybacks? How much is going to capital spending?
A company that doesn't pay dividends may be using the money to grow, a move that may ultimately pay off more than a cash payment. A perfect example: Microsoft.
A company can also express its stability via its balance sheet. When once-mighty companies fall, the grim reaper usually comes in the form of a creditor spurred on by a missed interest payment or a violation of debt covenants. WorldCom had the No. 2 long-distance position in the United States and some of the world's most valuable communication networks. Those assets were worth a lot, and brought in a lot -- but not enough to service nearly $25 billion in debt.
Coca-Cola, in contrast, has had numerous missteps over the past several years, but the company remains stable and profitable -- mostly because its products remain in strong demand and its management runs the business so smoothly, but also because it has less than $3 billion in long-term debt. Its dividend has never been in danger, and its stock price, though stagnant during the last two years of the bull market, has stayed steady during the market's downturn.
The volatility factor
You can also gauge a company's stability by answering the question, "How much does its stock fluctuate?" The term "beta" is used as a measure of volatility. The volatility of the market as a whole, by definition, is 1.0. Stocks that fluctuate more than the market have a beta higher than 1; those that fluctuate less than the market have a beta lower than 1.
What does that mean in practice? Look at two stocks of similar size: Qualcomm, with a beta of 1.8 -- one of the highest in the S&P 500 -- and Gillette, with a score of 0.5.
During September, in the space of 20 trading days, Qualcomm's stock value moved 3 percent or more eight times. During the same period, Gillette's stock moved 3 percent or more just three times. Regardless of what you may think of their outlooks, Qualcomm is simply too volatile to be considered a blue chip, while Gillette at least shows the even keel that characterizes stocks meriting that designation.