I had a conversation with an investor the other day who said that some very smart people who he trusted and respected had advised him that, in today’s economic climate, the only wise move was to buy the most conservative of blue chip stocks – namely, Canadian banks and utilities.
It’s easy to see the appeal of those big-name companies. For one thing, they seem to be virtually invulnerable. They offer high dividend yields that qualify for the Canadian dividend tax credit. They’re also extremely familiar. We walk by their big, brick-and-mortar buildings every day. Who wouldn’t feel comfortable entrusting their hard-earned money to these giants of industry?
Unfortunately, the real answer isn’t nearly that simple. As I told my friend, there are more than a few hidden dangers to this investment strategy, which could turn his guaranteed winners into long-term liabilities.
The first concern is that even companies that seem unassailable in one moment can look like dinosaurs in the next. History is littered with companies like Nortel and Enron that once dominated their space, but which have since disappeared – taking countless investors’ life savings with them.
Even companies that don’t go bust can be permanently compromised by changes in their environment. Numerous big pharmaceutical companies and even once-mighty GE, for example, are all still alive and kicking. But from an investment point of view, they’re only shadows of their former “blue chip” selves.
In my own practice, I have a client whose elderly parents live in the U.K. Her parents spent their lives accumulating a substantial portfolio of the U.K. equivalent of our blue chip stocks. Here in Canada, the financial meltdown of 2008 and 2009 more or less spared our banks. But if you lived pretty much anywhere else in the world (including the United Kingdom), those blue chip banks lost most of their value when they were re-capitalized by their respective governments.
Like so many other investors, my client’s parents had to watch as the portfolios they’d worked so hard to build were decimated overnight. Instead of leaving behind a legacy to take care of their children and grandchildren, they were forced to rely on the financial support of my client and her siblings just to make it through what were supposed to be their golden years.
Another risk to the blue-chip-only approach is the relatively low long-term rate of return they offer investors. A firm’s cost of capital is a good guideline for what investors who buy that firm’s stock should expect as a return on their investment. In other words, when giant blue chip companies borrow money, they borrow at very inexpensive rates. Their cost of capital is low, so in general, the return they give to investors over time is similarly low.
Smaller and riskier companies with a higher cost of capital may have more volatility than the bigger equities. But those risks can be easily diversified away through tools such as broad index funds. More importantly, that extra risk and volatility is precisely why those smaller and less well-known stocks also tend to offer a much higher long-term rate of return. If you only invest in blue chips, you’re effectively weeding the statistically best-performing facets of the market out of your portfolio. Over time, that can have a serious negative impact on your bottom line.
Speaking of diversification – from a global perspective, Canada is a tiny place. If you buy only Canadian blue chip stocks, you’ll end up with a portfolio that’s not only concentrated in just a few securities, but which is also made up entirely of a very limited number of sectors, in one very small geographic area.
Over the long run, diversification is the investor’s only true safe haven. You can pretend that nothing could ever possibly happen to those big “blue chip” companies. But as 2008 showed us, the value of even the biggest and bluest of stocks can be easily cut in half – precisely because most investors believed it couldn’t happen.
While Canadian banks have recovered their value, many much bigger banks around the world did not. If you lived in the U.K. in 2008 and had invested in only a handful of financial stocks, today, you’d probably be broke. On the other hand, if you had invested your money in a diversified global portfolio of thousands of equities from a multitude of sectors, you’d actually be worth much more now than you were in 2007.
Last but most definitely not least, there’s a dangerous trend in the international investment community that has been gaining speed with every passing year. The economist Joseph Schumpeter called it “creative destruction.”
Creative destruction is what happens when some 25-year-old genius (like, say, a young Steve Jobs or Bill Gates) comes along from out of nowhere and whips up something in their garage that renders an entire industry irrelevant. Every year, giants fall, and new giants jump up to take their place.
Don’t think it could happen here? Let me paint you a quick scenario that just might change your mind. I have a client who’s working on creating a new kind of microchip that is impervious to radiation. Since most of the weight in satellites comes from their lead shielding, if my client is successful, his chips will reduce the weight of an average satellite by around 90%. I’ll let you guess what’ll happen next to all those big companies that are making a fortune selling radiation-sensitive microchips today.
Still not convinced? How about a little mom-and-pop start-up by the name of Google? As I write these words, Google is working on a plan to ring the Earth with a network of satellites that will provide free Wi-Fi to everyone, everywhere on the planet. How much will you be willing to pay your Internet Service Provider for your monthly data plan, if you know you can get free Wi-Fi in the middle of the Sahara Desert? And how do you think that might impact the financial performance of the big ISPs like Bell, Rogers and Shaw – not to mention all the people who invested in them?
I’m not predicting Bell Canada’s imminent demise. They’re a great company with a lot of financial flexibility, and a lot of smart people who are very good at assessing the threats to their business. The point I’m trying to make is that, thanks to technology, the era of “creative destruction” is rapidly picking up speed.
It took the last 65 years for 40% of the companies in the S&P 500 to be replaced, merge with other companies, or go out of business. According to most experts, 40% of the companies that are on the major stock indices today likely won’t be here in their current form (or any form at all) in a mere 15 years. That’s a rate of disappearance that’s four times faster than it was during the last century.
Does that mean you should never buy any blue chip stocks? Not at all. Real diversification means owning both the blue chips and the small companies that will one day replace them.
Of course, if you decide to buy only blue chip stocks, no one will blame you for it, even if it turns out badly. After all, familiar names feel safe, and everybody does it, so you can’t go wrong. And even if you do, who could possibly have seen that coming, right?
Well… maybe you?
Alan MacDonald an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.
All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates. Past performance is not indicative of future results.
Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.
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