What are blue-chip stocks?

A blue-chip share is a company that's considered the best of the best, like a casino's most expensive (blue) chips. 

Blue chips represent financial stability, long-term growth, a strong track record, and even prestige. In fact, all the positive characteristics of being among the market's top companies for some time. 

There are no hard and fast rules about what makes a blue chip blue. Here are some of the characteristics of blue chips, how they perform, and how you can invest in them.

How to identify blue-chip shares

They are the market's biggest and brightest equities — the companies investors hold in the highest regard. Blue chips have usually demonstrated the following traits over many years:

• Financial strength: Low or modest debt, a strong credit rating, and plenty of cash
• Attractive business model and economics: Defensible market position and generates good cash flow
• Respected management team: Long-tenured executives with vital track records
• Long-term growth: Strong historical profit growth and expected to continue growing earnings in the future
• Strong performance: Share price has risen steadily over the long term and has exhibited reasonably low volatility
• Significant market capitalisation: Typically has a market cap among the largest in its industry, if not the largest.

These are some of the typical characteristics of blue chips. Most blue-chip shares should have just about all these traits but might miss one or two at any given point. 

For example, even the best and brightest companies can struggle to grow profits during a recession. But over the long term, blue chips have an excellent record of generating returns for investors.

A blue-chip stock typically belongs within a prominent share market index. The Dow Jones Industrial Average Index (DJX: .DJI) in the United States, for example. Australia has no official list of ASX blue chips, but the best place to start would be the S&P/ASX 20 Index (ASX: XTL).

Nabbing top shelf in the ASX 20 Index

The S&P/ASX 20 is an Australian share market index created and maintained by financial services giant S&P Global Ratings (S&P). It's the narrowest ASX index on offer by S&P and, as of August 2022, accounted for more than 40% of the Australian equity market. 

The ASX 20 index tracks the value of the 20 largest companies on the ASX, ranked and weighted by market capitalisation.

Market capitalisation refers to the total value of a company's shares within the share market. To calculate it, simply multiply the company's share price by the number of shares on issue. For example, if Company A issues one million shares and these shares trade on the ASX for $5 each, Company A's market capitalisation is $5 million.

How is the top 20 index made up?

To construct the ASX 20 Index, all ASX companies are ranked by market capitalisation, excluding exchange-traded funds (ETFs) and listed investment companies (LICs). 

The largest 20 shares that meet the minimum volume and investment benchmarks are eligible for inclusion in the index. This process is repeated quarterly to rebalance the index, adjusting for the inevitable changes in market capitalisation and liquidity.

When an index is weighted according to market capitalisation, a company's representation within the index is based on its size. In other words, the companies with the largest market capitalisation make up the largest part of the index. The larger the weight, the greater the company's influence over the index's day-to-day movements.

The S&P/ASX 200 Index (ASX: XJO) — the primary benchmark index when talking about Australian shares — is infamous for being skewed towards financials and, to a lesser extent, resources. 

Just look at the ASX 20 index sector weighting, and you'll see why. The big four banks and large mining companies like BHP Group Ltd (ASX: BHP) have historically dominated the Australian economy. This is reflected by the relative size of their market caps.

How do blue-chip shares perform?

Traditionally, the movements of the ASX 20 index closely resemble that of the ASX 200 index. This is to be expected because the ASX 200 is weighted by market capitalisation, so the largest shares have the greatest influence.

Blue chips aren't immune to the market downturns that are part and parcel of investing in shares. However, from operations to financing to strategy, size confers some huge advantages, and well-run blue chips use their size to improve their market position.

When size does matter …

Their typically larger size allows blue chips to outperform smaller companies for several reasons:

• Operational efficiency: Businesses that operate at scale enjoy the advantages of being more efficient, including more significant profit from synergies that smaller companies can't realise
• Financing edge: Whether it's via cheaper debt or more accessible equity, large companies command respect, and investors are more willing to lend them money due to their stability
• Strategic advantages: Unlike lesser-financed rivals, blue chips can actually acquire their competitors, especially during an economic downturn or recession when smaller companies usually struggle They can also divert customers away from a rival by leveraging industry power and connections. Size offers significant strategic opportunities to large, blue-chip companies.

Many blue-chip shares held up well during the COVID-19 pandemic as investors flocked to more mature companies with proven track records. Many of those companies that suffered share price falls early in the pandemic rallied strongly as value investors snapped them up on the cheap. 

This shows how, during a crisis, larger companies become more appealing to investors because of the business and financial security that their relative size provides. Investors rightly believe that these companies have greater resources available to weather short-term downturns in the economy.

Not all blue chips performed well, however. Major banks Westpac Banking Corp (ASX: WBC) and Australia and New Zealand Banking Group Ltd (ASX: ANZ) are still trading below their pre-COVID levels.

10 prominent ASX blue-chip stocks

BHP Group

BHP Group Ltd (ASX: BHP) is the largest miner in the world. It is also the largest company currently trading on the ASX, with a market cap of $190 billion. BHP has a long and storied history, being formed out of the merger of two mining companies — Broken Hill Proprietary (BHP) and Billiton — that were both originally incorporated in the 1800s.

BHP is among the world's largest coal producers and also produces significant amounts of iron ore, copper, and nickel. This diversification means BHP is not dependent on a single commodity's price to generate revenue.

This makes it a safer and more stable investment than companies focusing exclusively on one commodity, like Fortescue Metals Group Limited (ASX: FMG), a pure-play iron ore miner, or Newcrest Mining Ltd (ASX: NCM), a pure-play gold miner.

Commonwealth Bank

As the largest bank in Australia by a comfortable margin, Commonwealth Bank of Australia (ASX: CBA) needs little introduction for most ASX investors. CBA has a proven track record of success and has long been a staple of many 'mum and dad' share portfolios. In fact, it is arguably the most popular ASX blue-chip share with retail investors. 

Its popularity is likely due to people's familiarity with the CBA brand. At least at the beginning of their investing journey, many investors stick to companies that are present in their everyday lives. As Australia's largest bank, CBA is ever-present in our society. 

CSL

CSL Limited (ASX: CSL) is the undisputed darling of Australian healthcare, with a market cap of around $140 billion.

It began in 1916 as the Commonwealth Serum Laboratories, a government enterprise established to safeguard the health of Australians fighting in World War I. From there, CSL produced a vaccine for the 1919 Spanish Flu. Over the ensuing years, it has provided Australians with access to 20th-century medical advances such as insulin and penicillin.

Today, CSL competes on the world stage to deliver a range of life-saving and life-extending products to treat various medical conditions.

Woodside

Originally formed in 1954, Woodside Energy Group Ltd (ASX: WDS) has grown into Australia's largest independent oil and gas producer. Following its merger with the petroleum business of BHP in 2022, Woodside is now a top 10 global liquified natural gas (LNG) producer as well. 

It owns a diversified portfolio of energy assets in locations as diverse as Australia, Trinidad and Tobago, Senegal, and Canada — not to mention its many exploration projects worldwide.

Woodside's share price plunged at the outset of the pandemic in early 2020. It remained persistently low for most of 2020 and 2021 as lockdowns and other social restrictions dampened energy demand. However, its shares have rallied recently, largely due to the effects that the ongoing conflict in Ukraine has had on oil and gas prices.

Wesfarmers

Another company with a long history, Wesfarmers Ltd (ASX: WES) was established in 1914 as a cooperative of Western Australian farmers. Since then, it has grown into a diversified retail conglomerate that owns many well-known Australian brands.

Popular home improvement store Bunnings, office supplies retailer Officeworks, and discount department stores Target and Kmart all fall under the Wesfarmers umbrella. In addition to its retail operations, Wesfarmers also produces chemicals, fertilisers, and other industrial products.

Its share price held up well during the pandemic but has come under pressure more recently as runaway inflation threatens to squeeze retail margins.

Telstra

Another of Australia's most recognisable brands, telecommunications giant Telstra Corporation Ltd (ASX: TLS) has long been popular with retail investors thanks to its history of paying a consistent dividend.

Originally a state-owned enterprise, Telstra was first privatised in 1997 when shares in the company began trading on the ASX. The process of full privatisation took until 2011 when the Australian government finally sold the last of its stake in the telco.

Competition from new entrants to the telco market, like TPG Telecom Ltd (ASX: TPG) and Aussie Broadband Ltd (ASX: ABB), means Telstra isn't quite the safe utility company it used to be. However, it is still the country's largest telco and enjoys a significant market share.

Woolworths

Woolworths Group Ltd (ASX: WOW) is Australia's leading supermarket chain. Its first store — the extravagantly named 'Woolworths Stupendous Bargain Basement' — was opened in Sydney's Pitt Street in 1924.

By the mid-20th century, advancements in refrigeration technology allowed Woolworths to open fresh food stores around the country, and the company quickly expanded into more metropolitan and regional centres.

Nowadays, Woolworths Group employs almost 200,000 people across Australia and New Zealand, serving an average of nearly 23 million customers a week.

Transurban

Melburnians will be familiar with Transurban Group (ASX: TCL) as it operates the Citylink tollway that connects the city's major freeways.

Upon its founding in 1996, Transurban was initially restricted to operating the Citylink tollway only. However, the company reached an agreement with the Victorian government in 2001, allowing it to expand its operations.

Transurban now has stakes in multiple tollways across the east coast of Australia, as well as in the United States and Canada.

Santos

Since making its first significant natural gas discovery in South Australia's Cooper Basin in 1963, Adelaide-based energy company Santos Ltd (ASX: STO) has grown into one of Australia's largest energy companies and a dependable blue-chip share.

In addition to its operations at Cooper Basin, Santos has four other key oil and gas assets in Papua New Guinea, Timor-Leste, Queensland, and Western Australia. The company aims to become a leading liquefied natural gas supplier across the Asia-Pacific region.

Aristocrat Leisure

Finally, we have Aristocrat Leisure Limited (ASX: ALL). Given Aristocrat makes electronic gambling machines, including pokies, its line of business may not appeal to every investor. However, there is no arguing with Aristocrat's share price performance over recent years.

In the past decade, Aristocrat's share price has skyrocketed an eyewatering 1,200%, up to bona fide blue-chip status. If you had invested $10,000 in Aristocrat shares back in 2012, your holdings would now be worth well above $130,000.

Regardless of what you might think of the gambling industry, it's a real money earner, and Aristocrat continues to expand. The company has embraced digital technology and is now a market leader in free-to-play mobile games.

How do you buy blue-chip shares?

If you're looking to buy blue chips, you have several options. Here are two easy ways to buy the top companies in Australia:

Buy individual shares

First, you can buy any individual share in the ASX 20. Place the buy order with your broker, or use your online brokerage account to execute the trade, and you're all set. 

Put as much time and thought into investing in blue chips as you would for any other share purchase. You'll need to research and analyse the company to assess its future potential.

While blue chips may be a better breed of company, they are still subject to the same risk factors that can rattle the whole market. Always ensure you understand the share's risk and return characteristics and that they align with your investing strategy. 

Buy the ASX 20 index via an ETF

A good way to reduce your risk is to consider spreading your investment dollars over several different companies and not just one blue-chip stock. 

That's where the second option for investing in blue chips comes in: ETFs. These are sort of like mutual funds in that they pool money from multiple investors and then use that money to invest in shares.

However, unlike mutual funds, ETFs trade on the ASX like ordinary shares and are usually designed to replicate the returns of a specific index, like the ASX 20.

So, if you don't have the time or the experience to analyse individual shares, you can invest in an ETF. Voila! You now own all the biggest blue-chip shares on the ASX. 

This method has the added benefit of being cheaper than trying to buy each of the shares separately (since you'll incur brokerage costs per trade) — not to mention it's much more convenient, too. 

That said, if you decide to go down this path, you won't be presented with many options. At the time of writing, there's only one ETF of this variety: iShares S&P/ASX 20 ETF (ASX: ILC). This ETF is designed to track the 'accumulation' version of the ASX 20 index (before fees), which assumes that dividends are reinvested into the index.

Other options

However, if you were to broaden your horizons and consider a less narrow index, the range of ETFs to choose from suddenly expands. State Street Global Advisors offers the SPDR S&P/ASX 50 (ASX: SFY), and a handful of ETFs are designed to track the ASX 200, such as the BetaShares Australia 200 ETF (ASX: A200).

You also have the Vanguard MSCI Australian Large Companies Index ETF (ASX: VLC), which currently comprises 21 holdings and tracks the performance of approximately 70% of the investable Australian equity universe.

As a bonus third option to invest in blue chips, there's also WAM Leaders Ltd (ASX: WLE), a LIC provided by Sydney-based investment manager Wilson Asset Management. A LIC is an investment company that manages money for its shareholders, investing in companies according to its chosen strategy. You can invest in a LIC on the ASX just as you would a share or an ETF. 

This particular LIC, WAM Leaders, "provides investors with diversified exposure to a portfolio of undervalued growth companies within the S&P/ASX 200 Index and exposure to market mispricing opportunities in large-cap companies". So, instead of investing in an entire index, you'd be putting your faith in the investment team at Wilson to select companies within the ASX 200 that will ideally outperform the index.

However, this comes with higher fees than an index-tracking ETF, and the legal structure of a LIC is different from an ETF, among other things.

Should you invest in blue chips?

Investing in blue chips is a great way for beginner investors to dive into the stock market. Their businesses are already familiar to most people, making it easier to research and analyse them. 

New investors don't need extensive knowledge to start investing in blue-chip investments, either. ETFs make it simple to buy a diversified portfolio of shares. You can now gain exposure to broad sections of the stock market in a single trade.

Nonetheless, before you start investing, it's essential to understand your financial objectives and risk profile. For instance, the stability and reliability afforded by blue-chip shares can often come at the expense of returns. 

Therefore, investors with a longer investment horizon may skew their portfolio toward more high-risk, high-reward growth-oriented shares. This is because the more extended period will help smooth out the greater volatility associated with growth shares.

To get a good read on where you stand, go through our Beginner's guide to investing in ASX shares. It walks you through various topics, such as establishing an emergency fund, asset allocation, and understanding your investment goals. 

However you choose to invest, it's important to develop a strategy, stay the course, and stay Foolish.