Blue Chips or not?

For some investors, blue chips are the only companies which are worth picking up. They have had proven cash-generating ability, sustainable dividend yields, and also gone through some crises, and are a must in some portfolios. Whilst these may be true, however, the markets are largely efficient to the extent whereby blue chips are mostly fairly valued. There are hundreds of brokerages out there covering blue chips, and a million other investors out there which have their eyes on the companies, waiting to swoop in once some idea of inefficiency rears its head. As such, blue chips are likely to "market perform".

With these being largely true, value investors will tend to stray away from them. However, with the recent turmoil in the markets, some value seems to be emerging amidst the sell-down. Now, why should value investors stay away from them if their valuations have been beaten down? Only because of the notion that there are many other brokerage firms which are covering them, and thus a low likelihood that one would catch it when it is undervalued? I believe 2 main points actually disprove this idea for now.

1) fund redemption

There had been an increase in capital outflow from Singapore from mutual funds. This has led to a massive sell-down in equities. One can argue that the mutual funds are selling to the extent whereby the prices reflect the current financial turmoil, and that prices are reflecting the newsflows.

However, over 90% of trades a day are accountable by mutual funds (quoted from Pulses), so it is likely that massive sell-downs can be attributed to the large funds. So, if all the funds start to sell collectively, will there be any fund manager which would want to pick up stocks even though they are aware that value is compelling? It is highly unlikely that a fund manager would want to be caught catching a falling knife, especially so since their performances are tracked on a quarterly basis. Now, if all fund managers were to hold on to their holdings, would the markets be faring as badly? Probably not. But this is only likely to happen in an utopian world. This can be likened to the prisoner's dilemma, where few fund managers would want to dip their toes into the markets knowing well that other fund managers are still selling.

2) Other unforseen circumstances

One such example is margin calls. Let's all recall the performance of Keppel T&T over the past few months. It dropped from $4++ to <$1 at penny stock status in a matter of a few weeks, dropping 30+% compounded for 2 straight days. Reason? Fundamental change? Not really. A large shareholder (though not substantial enough to hit the 5% mark) was caught in a margin call and was forced to sell his holdings, resulting in the dramatic drop. It is currently trading at around 73 cents. Now, what on earth could have made a company lose 60% of its value over 2 days? Was the market valuing Keppel too highly before the drop? Or is the market valuing it too lowly after the drop? Mind you, Keppel T&T isn't exactly the kind of obscure stock where market inefficiencies might lie. It was a spin off from the Keppel conglomerate years back. Even though it has a low float, however, this is no reason for a huge discrepancy in the valuation in the space of 2 days. However, I have not seen its financials to be able to make a more informed stance on whether it is undervalued or not. Nonetheless, this is another prime example of how companies, even the better-known ones, can suffer from certain market inefficiencies.

Now, how can we know if a blue chip has been priced out of its fundamentals or not? One essential way is to look at how much of a fall that the markets have priced in. E.g. for property companies, this means taking a look at how much the markets are pricing in for a devaluation in the revalued net asset value. Now, if the markets have priced in too large of a fall (in your opinion), you might consider picking up the stock.

More importantly, blue chips are largely proven to have been consistent earners, and there is a high chance that earnings will go back on track after some hiccups here and there. Back to the definition of an undervalued stock again, which is to purchase stocks of a company when they are trading way below its intrinsic value. This intrinsic value is derived from its ability to generate earnings beyond the current 1-2 years, quite possibly even 5-10 years down the road. Now, blue chips have seldom fallen into this undervalued category, at least in my opinion. Was trying to bargain hunt for some blue chips but realised that the majority of them had been priced expensively, only until recently did it change. It does not mean that the small-to-mid cap stocks are the ones which are more likely to be priced inefficiently; the same can also happen to blue chip stocks, but only rarely, and possibly in bear markets like these.

The bottom line? No matter blue chip nor S-chip nor red chips, do your homework. True, blue chips can be covered by hundreds of brokerage firms around. But due to several reasons where value is emerging but nobody dares to purchase (factors as mentioned earlier), blue chips can still be hunting ground for value investors. Although the markets are efficient, there can still be opportunities abound. Information takes seconds to disseminate, but insight takes much longer.