Finding the best of the blue chips

By Harry Domash

The concept of buying blue-chip stocks is regularly bashed by the fast-money crowd. But they are wrong. If you don't believe me, just ask Warren Buffett.

Blue chips are companies of the highest quality -- substantial, well-established firms with widely accepted products that have recorded consistent sales and earnings growth over extended periods. They aren't the fastest growers or the most glamorous. But just like the Energizer Bunny, they just keep going and going.

How do find these blue chips? Size alone doesn't cut it. Otherwise, until recently, General Motors (GM, news, msgs) and Ford Motor (F, news, msgs) would have made the cut. Sure, blue chips must be large companies, but they must also have additional qualities that ensure that they'll still be considered blue chips five years down the road.

Here's how I used MSN's Deluxe Screener to pinpoint blue chips that will remain blue.

Only the biggest need apply

Blue-chip stocks, almost by definition, are those of large companies. They have the resources to survive the setbacks, such as management missteps and economic downturns, that sooner or later strike almost all companies.

Most analysts use market capitalization -- recent share price multiplied by the number of shares outstanding -- to define company size. The market cap is how much you'd have to pay to buy all of a firm's shares.

Market caps run from a few million dollars up to as high as $430 billion for ExxonMobil (XOM, news, msgs). If you ranked blue chips based on size alone, these would be the top five:

• ExxonMobil, $430 billion
• General Electric (GE, news, msgs), $366 billion
• Microsoft (MSFT, news, msgs), $284 billion (Microsoft is the publisher of MSN Money.)
• Citigroup (C, news, msgs), $262 billion
• Bank of America (BAC, news, msgs), $236 billion

How big is big enough? I figured that limiting the field to the top 2%, in terms of market cap, was a good place to start. So I set my minimum market cap at $50 billion, which was the nearest round number that approximated that figure. That limits the field to 130 or so of the more than 7,500 U.S.-listed stocks. Because I arbitrarily picked that number, feel free to move it up or down to suit your tastes.

Screening parameter: Market Capitalization >= $50 billion

Piggyback on S&P's work

Being a disciple of the "work smarter, not harder" philosophy, I let Standard & Poor's help me with the task of pinpointing the strongest stocks of the bunch. For its S&P 500 Index ($INX), S&P's analysts pick the best companies in each U.S. major industry. So I require S&P 500 membership to winnow out the weakest stocks. Doing that cut my list of potential blue chips down to 58 stocks.

Screening parameter: S&P Index Membership = S&P 500

Follow the big money

Continuing with the "work smarter" theme, I also let the big players help out. Thanks to the huge trading commissions that they generate, mutual funds, pension plans and other institutional buyers are wired into the system much more that you or I can ever hope to be. If that's not enough, many of them employ their own analysts to pick the best stocks. So if they don't like a stock, it probably doesn't belong on the list.

Institutional ownership is the percentage of a firm's shares held by the big players. In my experience, for stocks in favor with the big guys, institutional ownership typically runs between 60% and 95%. Thus I set my minimum institutional ownership at 60%, which cut my list of candidates down to 44 stocks.

Listen to the analysts

Yes, I know that some stock analysts let us down in the bubble years. Even so, analyzing stocks is their day job, and unless you enjoy dissecting financial statements, it makes sense to piggyback on their efforts.

Zacks Research and others compile analysts' buy-sell advice into the following categories: "strong buy, "moderate buy," "hold," "moderate sell" and "strong sell." Because some analysts don't like to use the "sell" word, many market players interpret "hold" as meaning "sell."

If anything, analysts are too optimistic. So it's bad news when they advise selling a stock. Consequently, I avoid stocks with "hold" or worse ratings.

Screening parameter: Mean Recommendation >= Moderate Buy

Analysts' long-term earnings-growth forecasts measure their expectations for a company's average annual growth over the next five years. Because share prices follow earnings, there's no point in buying a stock if analysts don't expect much earnings growth. Growth investors typically seek out at least 15% annual earnings growth. But because blue chips are already big, most grow annual earnings in the 10%-to-15% range.

Screening parameter: EPS (earnings per share) Growth Next 5 Years >= 10.

Adding those two analyst items cut my list of potential blue chip candidates down to only 18 stocks. Next, on to profitability.

Profitable companies only

Profitability means return on investment, which is different than reported earnings. Here's why that distinction is important.

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