These Blue Chips Will Kill Your Wealth

My article last week raised the ire of at least one of our subscribers.  He railed against my blue chip selection method, saying that he had bought GE -- "the bluest of blue chips" in his words -- and that he still lost money.

In my article I explained how to use a "quick & dirty" little formula to determine whether a blue chip stock was over valued or under valued.

The formula again is PE < (LESS THAN) Earnings Yield + Earnings Growth Rate.  So if the stock's PE is lower than the combined value of the earnings yield and earnings growth rate, then we would consider the stock under valued and worthy of our consideration.

I also said that there are two caveats.  The first is that this method is best suited to companies that have a durable competitive advantage, meaning that their business is not easily displaced.  Coca Cola is a prime example of a company with a durable competitive advantage, and GE certainly has a durable competitive advantage in many of its different businesses.

However the second caveat is debt, and by that measure I would be careful using this formula to buy GE, because GE's current debt load stands at $440 billion, with $210 billion of that debt due in 5 years or less! 

You must stay away from blue chips that have large amounts of debt because, no matter how cheap the stock gets if times get tough and credit dries up, having too much debt can choke a company to death.

This is exactly what happened to GE during the financial crisis: As the credit markets froze, GE couldn't find any buyers for its debt.  The stock looked cheap at $17 in 2008, and yet that didn't stop it from falling to $5 in 2009.  It was the debt that killed GE's stock.

In fact, if the Federal reserve hadn't stepped in, GE would have gone under.  Any company that is dependent on the continual issuance of debt in order to stay in business is a company at risk during times of extreme crisis.

So GE is not a good candidate for this method, but let's apply it anyway and take a look-see at how our subscriber could have saved himself the pain of GE ownership.

Let's assume that it's the year 2000, the stock market is just starting to roll over, but on a relative basis stocks are starting to look cheap.  So our subscriber friend takes a look at GE -- the "bluest of blue chips" -- with an eye to buy a bargain.

Was GE a bargain?

Let's run the numbers...

From 1996 - 2000, GE's compound annual earnings growth rate was 12%, and earnings for 2000 were $1.29.  On December 29, 2000, GE closed at $48, down from its high of $60.  It certainly got beat up... but was it cheap?

Here is our formula again:  PE < (LESS THAN) Earnings Yield + Growth Rate.  And here it is with the relevant parts filled in:

Dec 29th PE (37.2) < 2.68% Earnings Yield + 12% Earnings Growth Rate = 14.68

So our formula tells us that the most we can pay for the stock is 14.68 times earnings.  Earnings for 2000 were $1.29, which gives us a price of $18.94.  Remember, that’s fair value, that’s not even a discount.  So we can see that we absolutely cannot, and will not pay $48 for GE.

Now that didn't stop GE from gunning higher 5 months later.  The stock ran up to $53 during the May rally of 2000 before resuming its slide and bottoming at $21.40 during the 2002 low.  So by using this method we saved ourselves from suffering a 50%+ drop!

Time well spent, don't you think?

So was GE a buy based on its 2002 low?  Lets take a look once again...

From 1996 to 2002, earnings grew at an 11% compounded rate.  Earnings for 2002 were $1.51, and the stock's low for the year was $21.40.

2002 PE (14.17) < 7% Earnings Yield + 11% Earnings Growth Rate = 18

Our formula tells us that the most we can pay is 18 X earnings, which would give us a price of $27.18.  The stock is at $21.40 and so, at least by this one metric, it would be a buy.  If our subscriber was really intent on owning GE, this would have been the time for him to buy it based on this method.

Was it successful?

Indeed it was, as the stock soared from $21 and change to $42.

And yet for those poor souls who bought the stock at $48 back in 2000, they were still under water! 

So, was it GE to blame, or was the subscriber to blame for over paying?  I can tell you this:  No matter the business you are in, if you don't know how to value the "stock" that makes up your business, you will get clipped by other people that do.

So, even though I don't like GE because of its debt load, if you must buy this type of blue chip, make sure you but it cheaply enough to protect yourself.  Because it doesn’t matter how blue a blue chip may be, nothing can help you if you over pay for a stock.

And please remember, using this formula will not guarantee that you get the bottom.  But if you apply it to companies that have low debt levels and a durable competitive advantage, then you will be assured of getting a good price.

You still may have to deal with some extreme price volatility, but for long term investors looking to assure themselves that they did not over pay, this one formula is enough to get by on.

Teeka Tiwari
Chief Investment Officer
ETF Master Trader