Week 379 - Are “Blue Chip” Stocks Overvalued?

Situation: There are two subjective issues that we need to quantify for “buy and hold” investors: 1) Define a “blue chip” stock. 2) Define an “overvalued” stock. 

Our previous effort to define a “blue chip” stock in quantitative terms (see Week 361) left room for subjective interpretation and was more complicated than necessary. Here’s the new and improved definition: Any US-based company in the S&P 100 Index whose stock has been tracked by modern quantitative methods for 30+ years, and enjoys an S&P rating of B+/M or better. The very important final requirement is that the company issues bonds carrying an S&P rating of A- or better. 

In last week’s blog, we introduced two different quantitative methods for deciding whether or not a stock is overvalued: 1) the Graham Number, which sets an optimal price by using Book Value for the most recent quarter (mrq) and Earnings Per Share for the trailing 12 months (TTM); 2) the 7-Yr P/E, which removes aberrations that are introduced by “blowout earnings” or the negative impact on earnings that is often introduced by “mergers and acquisitions” and “company restructurings.” Either metric can be misleading if used alone, but that problem is largely negated when both are used together. 

Mission: Set up our Standard Spreadsheet for the 40 companies that meet criteria. Show the Graham Number in Columns X and the 7-Yr P/E in Column Z.

Execution: see Table.

Administration: In our original blog about Blue Chip stocks (Week 361), we thought the definition needed to require that companies pay a good and growing dividend. However, there are no objective reasons why a company’s stock will be of more value if profits are paid out piecemeal to investors rather than entirely in the form of capital gains. That’s one of the things you learn in business school from professors of Banking and Finance. Accounting professors also point out that a dividend is a mini-liquidation, as well as a second round of taxation on the company’s profits. There are subjective reasons to prefer companies that pay a good and growing dividend, like building brand value (an intangible asset) and showing that the company is “shareholder friendly.” Dividends also reduce risk by returning some of the original investment quickly with inflation-protected dollars.

Bottom Line: In the aggregate, these company’s shares are overpriced but not to an unreasonable degree (see Columns X-Z in the Table). However, only 8 are bargain-priced: Altria Group (MO), Comcast (CMCSA), Berkshire Hathaway (BRK-B), JP Morgan Chase (JPM), Bank of New York Mellon (BK), Wells Fargo (WFB), US Bancorp (USB), and Exxon Mobil (XOM). You’ll note that all 8 face challenges that will cause investors to pause before snapping up shares. 

Shares in 9 companies are overpriced by both metrics (Graham Number and 7-Yr P/E): Home Depot (HD), UnitedHealth (UNH), Lowe’s (LOW), Costco Wholesale (COST), Microsoft (MSFT), Texas Instruments (TXN), Raytheon (RTN), Honeywell International (HON), and Caterpillar (CAT). You’ll need to think about taking profits in those, if you’re a share-owner.

Risk Rating: 6 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-average into MSFT, NEE, KO, JNJ, JPM, UNP, PG, WMT, CAT, XOM, and IBM. I also own shares of COST, MMM, BRK-B, and INTC.

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