Higher interest rates means that stock picking is paramount. The Blue Chip Portfolio is designed guide you on building your own portfolio: protecting your wealth and building returns by providing stocks that are growing, but are not expensive. This is what fundamental investing is about – getting a dividend stream, while also providing the means to benefit from big economic forces. You should also combine your investment in Blue Chips with high growth Small Caps, enabling you to supercharge your returns.

Having said that, because we pursue a value philosophy, Blue Chips can hit the ball out of the park. Fortescue Metals (ASX:FMG) has returned 34% a year in the past 3 years and almost 40% in the past 12 months. Read our cover of AGL Energy (ASX:AGL) in BCV Issue 132, which has returned 55% since we upgraded it to Buy only 5 months ago (BCV Issue 123)!

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TIP 1: NOTE SECTOR WEIGHTS

Instead of trying to invest in every stock in a portfolio, or in a sector, identify some of the stocks in each of the sectors which you are comfortable owning. What you’re doing is identifying the best picks in each of the sectors.

In this week’s issue we also include our recently rebalanced portfolio (Issue 131, 9 June 2023). Access Now.

To summarise, the Blue Chip Portfolio is slightly overweight in the big mining companies, which includes its biggest weighting in BHP Group (ASX:BHP). Overall, “Basic Materials” represents 27%, versus their weighting in the S&P/ASX 200 Index benchmark of 24%. Banks and financials in the portfolio are 26%, almost the same as their weighting in the Index (27%). The Blue Chip Portfolio is skewed towards defensive stocks like Telstra (ASX:TLS), whose weight is 12% v Index 4%; and utilities like AGL Energy (ASX:AGL), whose weight is 4% against the index's 1.5%. Similarly, consumer staples like Coles (ASX:COL) has a heavier weighting.

As I’ve often said, we’ve got a value bias and it is a good idea to read how we work out our price targets, which I cover below and go into more detail in our next issue. Our system is based on valuing stocks utilising fundamental principles.

TIP 2: LOOK AT STOCK VALUATIONS

Investigate why a stock might be undervalued. To further help, I’ll distil our value process down a little further.

An asset’s value is based to a large extent on the future cash flows it generates, converted into present day dollars. We produce our price targets by compressing a discounted cash flow valuation process instead of forecasting cash flows/dividends for the next 30 years then discounting back at the discount rate. Our process involves taking the next two years’ consensus earnings and dividend forecasts and then looking at the valuation the market is giving the stock, based on its current market price versus the company’s book value per share (or net assets per share), which is similar to the price earnings ratio. A higher book value per share makes a stock more expensive, all things being equal.

Many fund managers try to add value by their ability to forecast earnings and dividends. We are not doing this; rather we’re taking the market forecasts as a given. You can do this with Blue Chip stocks because they are heavily covered by 10 or more brokers and by many more fund managers. This is where the value philosophy comes in.

For those who are technically minded, we are simply regressing the price to book (Left Hand Side) against the consensus earnings or dividends (Right Hand Side).

For any given stream of earnings and/or dividends, the price is either over valued or undervalued. By focusing on stocks where the expected return is positive, we are gravitating the portfolio towards a value bias.

TIP 3: ACT

Utilise our valuations and stock specific advice to act on managing your own portfolio – Buying and Holding/Buying More undervalued stocks; Holding fairly valued stocks and Taking Profits/Selling overvalued stocks.

Our process identifies based on earnings and/or dividend forecasts, if the price to book is the right level (Hold), too high (Sell) or too low (Buy). A Hold is based on an expected return between -10% and +10%. A Sell is where the expected return is lower than -10%, while a Buy is where the expected return is greater than +10%.

An important qualifier is that our analysts look at making sense of both the raw data our Blue Chip model outputs, as well as common sense. We will discuss this, as well as provide examples, in an article on how we generate price targets, in our next issue.

TIP 4: BLUE CHIP’S VALUE BIAS

Here’s another example. The bio-pharma blood specialist CSL Limited (ASX:CSL) has a history of generating big earnings growth, hence commands a high price to book value, higher than predicted against consensus earnings forecasts. Therefore it looks consistently over-valued. Another way to look at this is that CSL investors have been assigning a low expected return (or discount rate) to future cash flows. They are discounting future cash flows at a low rate, which is a characteristic of growth stocks.

Conversely, for value stocks, which in recent years have included the banks, Westpac Bank (ASX:WBC), ANZ Bank (ASX:ANZ), National Australia Bank (ASX:NAB) and the regional player, Bendigo & Adelaide Bank (ASX:BEN), investors are imputing, or assigning high expected returns (or a high discount rate) in order to justify giving them their money.

We prefer to invest in highly discounted stocks because they have a high expected return! Some of these stocks might have low earnings growth prospects, but it’s also about the price investors are paying, which generates that expected return.

TIP 5: TAKE ACCOUNT OF VOLATILITY

A point to make with our model is that we also consider return volatility, which refers to how much the share price moves. Those with higher movement or a larger standard deviation (variation from the mean) are more volatile and receive lower ratings than those with lower movement. We use a standard deviation of the past 250 days of share price returns. 

Some might be wondering why we don’t use return on equity for any of our calculations. The answer is that the data points are simply too few and far between, with companies only producing accounting based profit returns every six months.

FINAL TIP: BIG CAPS FOR INCOME, SMALL CAPS FOR GROWTH

Blue Chips are important for a reason: they have stable business models and generate income, generally year in, year out. They also access big themes. Small Caps have that all important growth potential, which you need in order to keep your own wealth well above the rate of inflation. The key in both asset classes is stock picking. With interest rates at more sensible levels, you need to be more judgemental about where to put your money. This is where Under the Radar Report and Blue Chip Value is invaluable.