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Are Blue Chips Really Safer Investments?

In Singapore’s context, the term “blue chips” is commonly used to refer to the 30 components of the Straits Times Index (SGX: ^STI).

As 30 of some of Singapore’s largest listed companies, the blue chips are also often thought of as safer and better investments than smaller firms. While there may be some truth in that generalization, it can be very dangerous for investors if it’s taken to the extreme.

Finding great investments

If we’d like to know the definition of what makes for a good investment, there could be no better person to turn to for answers than Warren Buffett.

Since taking control of Berkshire Hathaway in 1965 when it was then just a struggling textile mill, Buffett has helped grow the company’s book value (a good proxy for the economic value of the firm) by a breath-taking compounded annual rate of 19.4% over the past 50 years through astute investing in the shares of publicly-listed companies as well as the smart acquisition of private firms.

In his latest 2014 Berkshire Annual Shareholder’s Letter, Buffett included a section where he detailed his acquisition criteria when it comes to private companies. How Buffett thinks about private firms should also be carefully considered by stock market investors like us given that we ought to think of stocks as partial ownership stakes in a business.

To interest Buffett, a private company had to meet six different criteria of which two of the most relevant to stock market investors are given below:

“(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),

(3) Businesses earning good returns on equity while employing little or no debt,”

A tale of four

With that in mind, let’s take a look at the financial characteristics of four real companies, the identities of which I’d reveal later. What you need to know for now is that two of the four were blue chips back in 2009.

  1. Company A
    Company A (1)
    Source: S&P Capital IQ
  1. Company B
    Company B (1)
    Source: S&P Capital IQ
  1. Company C
    Company C (1)
    Source: S&P Capital IQ
  1. Company D
    Company D (1)
    Source: S&P Capital IQ

To sum up the tables above, Companies A and B had volatile profits, weak balance sheets (judging from the large negative net-cash positions), and erratic returns on equity over the five year period stretching from 2004 to 2009.

Meanwhile, Companies C and D were quite literally the exact opposites over the same timeframe: Both had consistently growing profits and had managed to generate healthy returns on equity while largely having strong balance sheets that were flush with cash.

If we were to view the four firms through Buffett’s lens, it wouldn’t be unreasonable to think that the latter pair, Companies C and D, would have made for much better investments than A and B.

The great reveal

Turns out, Companies C and D were indeed much better investments than A and B. At this point, it’d be good to reveal their identities:

  1. Company A’s palm oil producer Golden Agri-Resources Ltd (SGX: E5H) and it’s one of the blue chips back in 2009 (it still is today).
  2. Company B’s shipping firm Neptune Orient Lines Ltd  (SGX: N03) and it too, was a blue chip back in 2009 (the firm was unfortunately removed from the list back in 2012).
  3. Company C’s vehicle testing and inspection outfit Vicom Limited (SGX: V01).
  4. Company D’s healthcare services provider Raffles Medical Group Ltd (SGX: R01).

Since the start of 2010, Vicom and Raffles Medical have seen their shares soar by 182% and 209% respectively. Over the same period, Golden Agri’s shares had declined by 19% while Neptune Orient Lines’ had collapsed by 44%.

A Fool’s take

Golden Agri and Neptune Orient Lines have been poor long-term investments despite them being blue chips and that’s an important takeaway. Blue chips need not always be safer investments when compared with smaller firms. What matters at the end of the day is how a share’s business would perform in the years ahead.

Large firms must have done something right in the past to enable them to become the blue chips of today. But, things are always changing and investors ought to keep an eye on how a share’s business evolves, blue chip or not.

For more investing analyses and important updates about the stock market, sign up for The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway, Raffles Medical, and Vicom.