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Is It A Myth That Blue Chips Are The Safest Shares?

If you think investing in blue-chip shares is safe, think again.

According to Warren Buffett — the world’s richest investor — there’s something better. In his 1961 Buffett Partnership letter, Warren Buffet declared that his investments were more conservative than blue-chip shares.

Pardon?

How can that be true? Surely conservative, successful and safe companies back blue-chip shares such as HSBC Holdings (LSE: HSBA), Vodafone (LSE: VOD) (NASDAQ: VOD.US) and GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US). Firms that private investors, fund managers and pension schemes adore. They are the best and safest investments available, and that’s why they’re blue chip, right?

The trouble with that argument is that many confuse big with blue chip. Real blue chips are hard to find. There are several definitions out there, but I like this one:

“Blue chips are internationally recognised, well- established and financially sound companies. Blue chips generally sell high quality, widely accepted products and services. Blue-chip companies are known to weather downturns and operate profitably in the face of adverse economic conditions, which helps to contribute to their long record of stable and reliable growth.”

Size alone does not make a blue chip. Big cyclical firms such as HSBC and the other London-listed banks create portfolio destruction on a grand scale when times are tough. Such firms fail the ‘known to weather downturns and operate profitably in the face of adverse economic conditions’ part of the definition.Even mighty Vodafone is prone to the cyclicality of its industry, and we saw recently how patent expiry eroded the trading franchises of pharmaceutical firms such as GlaxoSmithKline.

Yet it gets worse. Think of the terminal decline in once-proud industries that we thought had ‘widely accepted products and services‘. How the mighty fell from favour. I’m thinking of names like Eastman Kodak Co, HMV and Yell Group. Look what happened to those bluer-than-blue-chip firms. Go back further and we can recall once-mighty operators such as Austin Motor, Bolsover Colliery, FW Woolworth and Cortaulds — how many investors saw those ‘safe’ blue chips take their investments to the metaphorical grave?

How Buffett did it

It seems to me that investors often look for safe investments that they can buy and hold for a very long time — hence the attraction of the arguably mythical blue chip. More than 50 years ago, during the period that he made his fastest portfolio gains, Warren Buffett shunned that kind of fire-and-forget mentality and didn’t invest in the blue chips of the day. It was many more years and many millions of gain before he uttered the well-known words “our favourite holding period is forever”. The reality of his earliest and most successful investing, in terms of percentage gains, is that his favourite holding period was until he made a good profit, and then he would likely sell.

It’s well known that Buffett traded value: he bought shares when they undervalued a company, and he sold them when the value had ‘outed,’ or when he was showing a decent gain. Sometimes both conditions were present when he sold, and sometimes he just sold to take profits. He made millions by first protecting the down side with a decent margin of safety and then by taking profits when he could. For that strategy to work, he invested in smaller companies than the blue chips of the day. Blue chips then, as now, rarely display the required safety margin due to all the billions pumped into the shares by institutional and private investors.

Buffett considered his small-cap, safety-first strategy to be more conservative than investing in blue chips. His one caveat was that the approach worked best during stagnant or moderately declining markets. Hello! That sound just like the conditions we have right now!

Superior returns

According to Buffett, superior returns are possible, and more safely achievable, by investing in smaller companies than blue chips. That’s unsurprising when we look at the earnings-growth rates available for some of our ‘blue chips’. For example, City analysts expect HSBC to score just 5% growth during 2015, GlaxoSmithKline to post a scant 1% and Vodafone to see a 9% uplift during 2016. Such performance is not likely to set a portfolio on fire.

So, why not build a more conservative portfolio by adding some well-run, smaller companies to the mix, without forgetting that all-important margin of safety. It really is a myth that blue chips and big FTSE 100 firms offer the safest shares. To me, the safest form of investing is to make good returns — it’s amazing how secure a growing cushion of funds makes us feel!

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended GlaxoSmithKline and HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.