If you have ever wondered what blue chip dividend stocks are, why they are attractive, where you can find them, and what the best ones are, you have come to the right place.
What are Blue Chip Dividend Stocks?
The story goes that Gingold was at a brokerage firm when he observed several trades that took place at high prices (e.g. $200 per share) and said to nearby securities analyst Lucien Hooper that he planned to write about these “blue chip stocks” when he returned to his office. The term initially referenced stocks with high share prices but is more commonly associated with high quality today.
The “blue chip” term used by Gingold actually comes from the game of poker. The simplest set of poker chips comes in three colors – red, white and blue.
As you might have guessed, the blue chips are the highest in value. While not all blue chip stocks pay a dividend, most do because they are generally mature businesses and have significant retained earnings and cash flow to distribute.
Blue chip dividend stocks are typically large in size (e.g. market caps exceeding $10 billion), have tremendous financial strength, maintain leading roles in the economy, generate dependable earnings, and are thought to be much safer and more durable than the average stock.
Most of these companies have paid and increased their dividends for many years as well, a signal of financial strength and stability.
Blue chip dividend stocks are popular in part because of the contribution dividends have had to the market’s overall return. According to S&P, since 1926, dividends have contributed nearly a third of total equity return while capital gains have contributed two-thirds. Dividends also suggest a company is profitable, stable, and confident in its long-term outlook.
Blue chip dividend stocks have generally proven to be some of the most durable companies around and appeal especially to conservative investors interested in holding stocks for many decades. While blue chip stocks aren’t guaranteed to be great investments, they are a good starting place to look for high quality businesses.
How to Find Blue Chip Dividend Stocks
Famous value investor Ben Graham noted in his book “The Intelligent Investor” that conservative investors should seek out companies that have been paying out steady dividends for at least 20 years.
Consistent dividend increases are often a sign of dependable profits and management’s confidence in the future of the business. These are all reasons why income investors often flock to groups of stocks such as dividend aristocrats (S&P 500 companies with 25+ consecutive years of dividend increases) and dividend kings (50+ consecutive years of dividend increases).
Comparing the list of Fortune 500 companies in 1955 to the most recent Fortune 500 list, fewer than 65 companies are on both lists. Said another way, over 85% of the companies from 1955 either went bankrupt, merged, or fell from the top 500 companies as their businesses shrank.
According to a study of the S&P 500 Index conducted by consulting firm Innosight, the rapid pace of technological change, increased globalization of economies, and intensified pressure from startups is shortening the average life of companies even more today.
The report noted that the 61-year tenure for the average firm in 1958 shrank to 25 years in 1980 and 18 years in 2011. In other words, using the churn rate observed in 2011, 75% of the S&P 500 would be replaced by 2030!
A Wall Street Journal article about blue chip dividend stocks in 2014 highlighted some of the challenges recently faced by these massive businesses. It notes that many of these companies were so successful that the large revenue base they built up made them too big to switch strategies quickly when market conditions changed. Some examples it lists of blue chip companies struggling for profitable growth are Walmart, IBM, AT&T, and Coca-Cola.
While they are all still cash cows, blue chip dividend stocks must reinvest and shift their sales mix to rejuvenate their prospects for long-term earnings growth. Otherwise, over the next several decades, they risk becoming just another statistic.
Capitalism makes our lives better every day in the form of new products, increased conveniences, lower prices, and more. However, it can create headaches with our investments if we are not careful with our diligence process.
Blue Chip Dividend Stocks – Investment Checklist
Sometimes the best-performing, most consistent dividend growth stocks are tied to a long-tailed cycle that is about to end – either from demand reaching a peak or new supply entering the market (changing consumer preferences, new competition, technological change, etc.).
What macro factors is the stock sensitive to? Have those factors been benefiting from unsustainable sources of demand or unreasonably constrained supply?
Most things in life are cyclical – understand what cycles might be driving your stocks and where they are in their lifecycle. On the flip side, investing in long-tailed themes that are closer to their beginning than their end can be a great investment strategy.
Item 2) Do recent business trends raise any red flags about how the world is changing?
If sales have started declining or profitability has stalled, you need to determine if the factors causing those results are temporary or the start of a long-tailed headwind.
If it’s the latter, remember how difficult it is and how long it takes for large blue chip dividend stocks to shift their mix into profitable areas of growth. There might be an even better entry point six months down the road.
Without free cash flow, companies have fewer resources at their disposable to continuously reinvent themselves and can also be more dependent on access to credit markets. Both of these factors can significantly shorten a company’s lifespan.
If a negative shock occurs and a business is saddled with heavy amounts of debt, limited cash reserves, and declining cash flow, the value of your investment can plummet. The dividend could also come under pressure, depending on the severity of the struggle.
Think about how fast end markets are growing (e.g. about in line with GDP), what secular themes support long-term growth (e.g. rising consumer wealth in emerging markets), the reasonable paths a company has to expand into adjacent markets (e.g. Coca-Cola using its distribution network to launch healthier beverages), and the ease at which new competition could enter or change the market’s dynamics (e.g. imports from new China, technology advancements, etc.).
The payout ratio measures how much cash flow or earnings a company’s dividend is consuming. We prefer to see dividend growth in excess of the rate of inflation (3%+ per year) and stable payout ratios, meaning the dividend is growing in line with cash flow growth.
For cyclical companies, we like payout ratios below 50% (and healthy balance sheets). For more stable businesses, payout ratios less than 70% are desirable.
Lower payout ratios provide more cushion for the dividend and opportunity for growth, even if earnings growth temporarily slows.
Closing Thoughts on Blue Chip Dividend Stocks
Data shows that the average lifespan of an S&P 500 company has dropped from 61 years in 1958 to less than 20 years more recently. Companies that were once dominant giants are more vulnerable to change than ever before.
Run each of your ideas through our blue chip checklist and conduct additional research to give yourself the best chance of investing in dividend stocks that will not only survive the next storm but emerge with higher dividend payments and more cash flow coming in the door.