In the switch of Nvidia superseding Intel in the Dow Jones, is it appropriate to revise the definition of a Blue Chip Stock?
The Dow Jones Industrial Average (DJI) is undergoing its second significant transformation in 2024. Previously this year, Amazon (AMZN) replaced Walgreens Boots Alliance, and now, Nvidia (NVDA) is swapping places with Intel, while Sherwin-Williams is taking over from chemical behemoth Dow.
This shift in the 128-year-old index signifies a broader market leadership shift, and the very essence of what constitutes a blue-chip stock might require revision.
In with growth, out with high yield
The term "blue chip" derives from poker, where it refers to the highest value chip. Although there isn't an official definition of a blue-chip stock, traditionally, all 30 components of the Dow, coupled with companies that have sustained dividend hikes, such as Dividend Kings, fall under this category. Dividend Kings are entities that have augmented their dividends for at least 50 consecutive years.
Though the majority of Dow stocks offer dividends, not all do. For instance, in August 2020, Salesforce replaced ExxonMobil in the Dow, becoming the third non-dividend-paying component, after Boeing and Walt Disney halted their quarterly payouts earlier in the year. Nevertheless, Salesforce introduced a minor dividend this year, and Disney has since restarted its dividend, albeit at a reduced amount.
Amazon does not pay a dividend, but Nvidia does, albeit only technically so, offering $0.01 per share per quarter. In contrast, Sherwin-Williams yields 0.8%, whereas its replacing entity, Dow, boasted one of the index's highest yields, at 5.7% as of recent pricing.
After the adjustment, there will be only 16 Dow components yielding 2% or more, and eight producing yields of 1% or less.
Historically, the Dow was abundant in dividend-centric entities. Presently, the focus has shifted towards industry leadership, replacing the prior focus on dividends.
Understanding dividends and capital allocation
To fathom why dividends are crucial to the image of a blue-chip stock, we must first comprehend why companies pay them in the first place.
A dividend is a means for a company to directly distribute earnings to its shareholders. If a company can pay consistent dividends over a significant period, its business health is likely robust. If the company can escalate its dividend yearly, it demonstrates earnings growth, enabling the distribution of even more profits to shareholders.
However, dividends are just one method for a company to distribute capital. A company can decrease its debt, maintain excess earnings as cash or cash equivalents, or marketable securities. It can also repurchase shares, which reduces the share count and increases earnings per share. Alternatively, it can engage in mergers and acquisitions (M&A) or pour money into the business to spark organic growth.
Most traditional blue-chip Dow stocks have limited growth prospects or business models that don't necessitate ever-increasing investment. For example, shareholders of Coca-Cola wouldn't desire the company to invest its excess profits in dangerous research and development projects to develop the next great soda. Similarly, Procter & Gamble wouldn't feel content throwing money on a dartboard in the hopes of inventing a game-changing product. Even a company like JPMorgan Chase would prefer gradually growing its network and client base instead of overextending itself and threatening its stability. Therefore, these companies primarily rely on dividends as a means to reward shareholders with passive income, irrespective of the stock market's fluctuations.
Conversely, today's most valuable companies are largely considered growth stocks. Dividends can be a factor, but they are not the primary focus. Companies such as Apple and Microsoft only pay dividends below 1%. Meanwhile, Alphabet and Meta Platforms began paying dividends earlier this year, but these still yield below 0.5%. A commonality among all these entities is their emphasis on buying back a substantial amount of their own stock.
Prioritizing capital to buy back shares instead of paying dividends shows management's confidence in the stock's intrinsic value and its potential to outperform dividends over time. Indeed, this strategy has proven successful for tech giants like Apple, Microsoft, Alphabet, and Meta, outperforming the market long-term.
Despite not paying dividends, Berkshire Hathaway, led by Warren Buffett, is often considered a blue-chip stock for its ability to generate higher returns for investors through capital gains, rather than dividends. Although devoid of dividends, many might still label Meta and Alphabet as blue-chip stocks, despite their minimal yields and their brief history of paying dividends compared to decades-long tenures. But what about companies that don't offer substantial dividends or buyback programs?
Recent Dow entrants Amazon and Nvidia dilute their shareholders through stock-based compensation. Amazon is renowned for investing in a diverse array of industries by utilizing excess profits, leading to an increased share count over the last decade, but still boosting the stock price by over 13-fold. Therefore, it's challenging to refute Amazon's aggressive capital allocation strategy.
The "blue chip" title should primarily be associated with companies that excel in market leadership and make the most of their capital investment, regardless of whether it's directed towards dividends, buybacks, mergers and acquisitions, or organic growth. However, if a company opts for the more daring approach of firms like Amazon or Nvidia, it's crucial for them to demonstrate that their capital outlay is beneficial.
Paraphrasing isn't about changing words while preserving the meaning; it's about expressing the main idea in unique language. In this context, I sought to convey the original meaning without directly repeating the words used in the original text.
In the context of this market shift, individuals focused on finance and investing might be interested to know that the Dow Jones Industrial Average (DJI) is now home to fewer high-yielding stocks, with only 16 components yielding 2% or more after the recent changes. Moreover, the emphasis on industry leadership has led to a decrease in the number of dividend-paying entities, with eight now producing yields of 1% or less.
While understanding the role of dividends in the image of a blue-chip stock, it's important to remember that companies pay dividends as a way to distribute earnings to shareholders, demonstrating business health and earnings growth. However, dividends are just one method for capital allocation; a company can also repurchase shares, invest in organic growth, or engage in mergers and acquisitions. Traditional blue-chip companies like Coca-Cola and Procter & Gamble primarily rely on dividends as a means to reward shareholders, while today's most valuable companies, such as Apple and Microsoft, prioritize capital to buy back shares instead, showing management's confidence in the stock's intrinsic value.
