The Risk Return Puzzle For Blue Chips

January 5, 2018

The Risk Return Puzzle For Blue Chips

  • Developed markets stocks are a core position of an All-Weather portfolio.
  • However, there isn’t the pricing efficiency you would expect.
  • Take a long look at what you own and the risk reward of it, you’ll probably be surprised.



Introduction

If you’ve beer reading the last few weeks, you’ve been following my series on how to build an all-weather portfolio. You can read more about the gold part of the portfolio here, the commodities part here, and the hedging part here.

Today, I’ll discuss blue chip stocks and their risks and rewards in order to determine how much weight such stocks should have in an all-weather portfolio.

I’ll discuss 5 blue chip stocks to see what their risk reward is. This will allow you to see how much of your portfolio you should allocate to similar stocks.

A blue chip is a company that has a stable business and a long operating history.

Blue Chip 1: Exxon Mobil (NYSE: XOM)

XOM has managed to remain profitable even during the recent slump in oil prices. Given the current surge in oil prices, we can expect strong cash flows from XOM, a continuation of the small and constant dividend raises, and positive earnings.

If oil prices stay above $60, XOM’s price to earnings ratio should be around 15 which is below the current market average. XOM’s stock price has shown extreme stability during the last two years.

Figure 1: XOM’s price during the last three years. Source: CNN Money.

The story for XOM is pretty simple. The stock price is going to fluctuate in relation to oil prices, but the dividend is pretty safe no matter what happens. Therefore, investors can expect a dividend yield of 3.5% or 4% which is good and the risk isn’t that high due to XOM’s stability and low-cost production.

I would say the maximum downside for XOM is 50% which is much less than what the downside is for the gold miners and metal miners we’ve discussed in previous articles. Therefore, XOM should have an adequate weight in a portfolio.

Let’s look at other blue chip stocks for perhaps greater rewards for the same risk.



Blue Chip 2: Target Corporation (NYSE:TGT)

TGT is another blue chip that has a price to earnings ratio of just 15 and pays a dividend of 3.76%, but the stock price has been much more volatile than XOM in the last few years.

The price to free cash flow is just 7.6. The issues with TGT come from the fears related to AMZN’s competitive pressure and stagnating revenue with declining earnings. This makes TGT riskier than XOM with the same yield and therefore would lead to a smaller portfolio allocation.

Blue Chip 3: Emerson Electric (NYSE: EMR)

The difference between the two companies we’ve discussed above and EMR is that EMR has a price to earnings ratio of 27, which makes EMR almost twice as expensive as XOM or TGT.

Earnings, revenue, and debt levels have been extremely stable in the past while the dividend has been continually increased. Nevertheless, the risk with EMR is huge.

If interest rates rise significantly and the 10-year treasury yields 4%, the required dividend from EMR will be around 6%. This would imply a stock price of $33 and a 54% downside. Think my downside it too much? The stock price was at $26 in 2009 with almost equal earnings.

Figure 2: EMR’s stock price in the last 10 years. Source: Yahoo Finance.

EMR is really the riskiest stock we’ve discussed so far. I know the sentiment is positive around it, but that can quickly change and the chart shows it often changes, so be careful with this one.

Blue Chip 4: Walgreens Boots Alliance Inc (NYSE: WBA)

WBA is a blue chip that, unlike the companies we’ve talked about so far, has managed to double its revenue in the last 10 years which makes it a growth blue chip stock.

Earnings have also doubled while the dividend yield is just 2.13%, however the pay-out ratio is also low at 40% which leaves plenty of money to finance more growth. The price to earnings ratio is around 20, implying a 5% earnings yield which is better than what the S&P 500 offers.

WBA’s business model is relatively recession-proof while the main question is still Amazon. Can Amazon bring disruption to the pharmacy business? That’s a difficult question to answer, but what we do know is that WBA’s downside isn’t that big thanks to the global growth it offers.

Given the valuation some companies without growth have, WBA seems a better play. In the worst-case scenario, I would put a 30% downside to WBA while the upside comes from the 5% earnings yield and a continuation in growth through acquisitions. The growth of WBA is what creates value and differentiates it from the previously mentioned companies.

Figure 3: WBA’s global footprint. Source: WBA.

Blue Chip 5: The Boing Company (NYSE: BA)

The global sentiment surrounding air transportation is extremely positive given the growth coming from emerging markets and local low-cost carriers. This has brought BA to a price to earnings ratio of 27 and a dividend yield of 2%.

BA has had relatively flat sales over the past few years, but it has seen a significant improvement in its gross margin of 300 basis points and the management has increased the dividend by 150% in the last few years.

BA’s stock was one of the best performers of 2017 as the stock jumped 88%. What’s even more significant is that BA’s stock is an almost 10 bagger since 2009.

Figure 4: BA’s stock price has taken off since 2009. Source: Yahoo Finance.



The issue here is that the airline industry has always been cyclical. Many airlines order new planes years ahead, but there are also plenty of cancellations when the market gets saturated or there is an economic slowdown.

At current stock prices, BA is an extremely risky stock, the dividend yield of 2% might be there for another year, two, or even three, but is extremely small for what can happen to BA. Let’s say earnings drop to the average of $5.9 for the last 10 years while the price to earnings ratio drops to 15 due to the drop in earnings. BA’s price would then be below $90, implying a 70% decline. Of all the stocks mentioned, BA seem to be the riskiest one, alongside EMR.

Conclusion

You’d expect blue chip stocks to be equally priced in relation to their risks and rewards. However, that is not so because, in my opinion, this market is extremely driven by sentiment. Some companies have stability, growth, and a low valuation while others have no growth and an extreme valuation. This isn’t bad because it allows the intelligent investor to position themselves with low risk high potential reward investments.

Make sure to assess how much risk your developed world blue chip portfolio carries and attach an adequate weight to it. As you have seen with the companies I’ve described above, the good news is that you can find healthy growth, and a good yield with limited downside which enables the creation of a strong developed market portfolio.

Keep reading Investiv Daily as we will soon discuss the risk and reward for emerging market stocks.



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