A blue chip stock is a stock that's considered the best of the best, like a casino's most expensive (blue) chips. Its name commands financial stability, long-term growth, a strong track record, and even prestige -- all the positive characteristics that come with being one of the world's top companies, and having held that position for some time.

In this sense, a blue chip could be any top stock, but it also has a more specific meaning in everyday life -- referring to the 30 stocks in the Dow Jones Industrial Average, or the Dow. When financial commentators and traders rejoice or lament "how the blue chips performed today," they are talking about the stocks that make up the Dow. Here are the characteristics of blue chips, how they perform, and how you can invest in them.

Blue poker chip on a stock chart

Image source: Getty Images.

What are blue chip stocks?

Blue-chip stocks are the market's biggest and brightest equities -- the U.S. 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 position, and generates good cash flows.
  • Respected management team -- long-tenured executives with strong track records.
  • Growth over the long term -- shown strong growth and future growth is promising.
  • Strongly performing stock -- stock price has risen over the long term.
  • Large market capitalizaton -- among the largest in its industry, if not the largest.

These are some of the major characteristics of blue chips, and while most blue chip stocks should have all of these traits, they might be missing one or two at any given moment. During a recession, even the best stocks can struggle to grow profits. But over the long term, blue chips have an excellent record of generating profits for investors.

Which stocks are in the Dow Jones Industrial Average?

By definition, the 30 stocks in the Dow Jones average are large-cap blue chips, selected because they represent the overall performance of large American companies. Familiar names in the Dow include Apple, Visa (NYSE:V), Wal-Mart, and Coca-Cola. The index is price-weighted, which means the percentage a stock occupies in the Dow is determined by its relative stock price compared to its Dow peers.

The current blue chips aren't necessarily blue chips forever. The last original Dow pick that remained in the index finally got the boot in 2018, when General Electric was replaced by Walgreens Boots Alliance. The stock of once-mighty GE had performed horribly over the prior year, which called the company's financial stability into question. These relatively rare changes are decided by the S&P Dow Jones Indices, a joint venture between S&P Global (NYSE:SPGI) and CME Group (NASDAQ:CME). Founded in 1896, the index's composition has only been changed 50 times, which is remarkable given the transformation in American business over that time.

Typically the index manager adjusts the index every few years, but changes aren't made on a fixed schedule. The index changes when the index manager decides a change would help it better reflect the leading American companies. In 2018, General Electric was asked to leave. From 2011 to 2018, the index replaced six companies. Sometimes, companies that are kicked off the list find their way back onto it; AT&T and United Technologies have revolved on and off the list over the decades -- AT&T is now off, and United Technologies remains.

How do blue chips perform?

Over time, blue chips have performed similarly to the Standard & Poor's 500, a stock index that combines the Dow's 30 companies, but in different proportions, with 470 other large companies intended to capture the country's top businesses. Both indexes have an average total return of about 10% over the long run.

If a blue chip doesn't perform well for a long stretch, the stock can be booted from the Dow, so the blue chips must perform well in order to stay blue chips. From operations to financing to strategy, size confers some huge advantages, and well-run blue chips use their size to improve their market position.

Blue chips tend to outperform smaller companies for several reasons:

  • Their large size gives them operational efficiency. Businesses that operate at scale enjoy the advantages of being efficient, including profits from synergies that smaller companies can't realize.
  • Their large size gives them a financing edge. Whether it's via cheaper debt or easier equity, large companies command respect, and investors are more willing to lend them money due to their stability.
  • Their large size gives them strategic advantages. Unlike lesser-financed rivals, blue chips can actually acquire their competitors, when they're able to, especially during an economic down turn or recession, when smaller companies stuggle. Or perhaps they can divert potential customers away from a rival by leveraging industry power and connections. Size offers significant strategic opportunities to large, blue chip companies.

With a 10% annual return, the Dow does well for investors. But that doesn't mean each blue chip stock returns 10% every year, or even most years. In fact, the Dow lost nearly 6% of its value in 2018. Nevertheless, many stocks performed well.

In 2018, the Dow's three top-performing stocks were:

  1. Merck -- up 36%
  2. Pfizer -- up 20%
  3. Microsoft (NASDAQ:MSFT) -- up 19%

The three worst-performing Dow stocks in 2018 were:

  1. Goldman Sachs -- down more than 34%
  2. IBM -- down nearly 26%
  3. DowDuPont -- down almost 25%

While the blue chips were down for the year, the reasons had more to do with trouble at the respective companies rather than signs of trouble in the broader economy.

Top blue chip stocks for investors

These blue chip stocks represent a wide swath of American businesses. Here are three of the most popular and where they stand now.

1. Visa

Everyone knows Visa -- it's everywhere you want to be, as its jingle goes. While Visa has been a brand name for decades, the company only went public in 2008, when the banks that owned the payment network decided to cash out their investments. It was the largest U.S. IPO ever, and Visa joined the Dow in September 2013.

With a market capitalization of $342.2 billion, Visa is already large -- but it should have plenty more room to grow because the company is entering the e-commerce space. Through its card network, Visa effectively takes a piece of every transaction it processes, so the incremental returns on the company's investment are enormous. Visa stands to benefit from the growing "war on cash," or society's movement away from using paper money, instead preferring debit or credit cards as wellas financial technology solutions like Apple Pay and Venmo, which is owned by PayPal.

The company has forged strategic networks with big U.S. banks as well as more upstart payment solutions such as PayPal to ensure that Visa remains the network of choice. 

2. McDonald's

Fast-food all-star McDonald's (NYSE:MCD) is everywhere. Few sights are more welcome to a traveler's eyes than the Golden Arches, especially with hungry kids in tow. That's part of the reason restaurant powerhouse McDonald's joined the Dow back in October 1985. 

While McDonald's is world-famous for its Big Mac and french fries, it's much less involved in the restaurant business than consumers realize, because McDonald's is largely a franchisor of its locations, rather than an operator, and the company has been shifting toward a more franchisee-based model for a long time. More than 90% of its locations are owned and operated by independent franchisees, and McDonald's plans to move that number to around 95% in the long term. This benefits investors because third-party owners invest the capital, while McDonald's takes a cut of sales in the form of a royalty payment, which means McDonald's has to invest very little of its own capital to grow its business.

All of that excess free cash flow goes into share repurchases and dividend growth, which supplement the earnings per share (EPS) received by investors. Share repurchases happen when a company's management decides to buy its own stock back, which is why they're also called stock buybacks. These can make the stock more valuable for investors who already own it.

The franchise business model gives McDonald's a hidden asset: real estate. While the franchisee has the right to operate under the McDonald's banner, the parent company retains the rights to most of its land and buildings and charges the franchisees rent. With a popular brand, a strong franchise model, and the profits from its global real estate, McDonald's can still be a powerhouse investment, especially if you're looking for stocks that pay dividends.

3. Microsoft

Alongside Apple and Amazon, which is not a Dow component, Microsoft is one of the world's most valuable companies. It joined the index in November 1999, during the height of the dot-com boom, along with tech bellwether Intel. It was the index's first foray into the new "tech" world, and it has worked well. In fact, Microsoft finished 2018 as the most valuable company on the U.S. exchanges, a spot it hadn't held since 2002.

The Washington-based software juggernaut has been reinventing its business, moving from a one-off sales model to a subscription-based model. Key products like the Office suite of workplace tools require a monthly subscription, but the company continually updates the products with the latest features, rather than requiring customers to buy an updated software product. This appears to be working, as Microsoft's profits have soared in recent years.

Microsoft has a cloud-computing platform called Azure, which has been selling like hotcakes as an alternative to Amazon Web Services (AWS). Microsoft has been making high-profile deals with companies that prefer using its cloud program to getting further tied up with Amazon, including recent deals inked with Walgreens and Wal-Mart. 

How do you buy blue chip stocks?

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

  1. Buy individual blue chip stocks.
  2. Buy the Dow index whole via a fund.
  3. Buy a modified index fund that is a variation of the Dow.

First, you can buy any individual stock in the Dow just as you would any other stock. Place the buy order with your broker, or use your online brokerage to make the trade, and you're all set. Exercise the same care in investing in blue chips that you would for any individual stock. You'll need to use your investment process to analyze the company and assess its future potential. While they may be a better breed of company, blue chips are still subject to the same factors that can rattle the whole market. That means they can decline, sometimes precipitously, if bad news hits the headlines. Even the best blue chips do poorly from time to time, especially during recessions. So, that's one reason you need a diversified portfolio of companies, not just one blue chip investment.

And that's where the second option for owning blue chips comes in, especially for newer investors who aren't comfortable analyzing individual stocks, or for investors who are pressed for time. You can simply own the entire lot of blue chips by buying an index fund based on the Dow. This means you own the market -- and the market returns about 10% annually over a long time. That's cheaper than trying to buy each of the stocks separately, and it's much more convenient, too.

You can purchase an index fund based on the Dow as an exchange-traded fund (ETF). The most famous is the SPDR Dow Jones Industrial Average ETF (NYSEMKT:DIA). Its goal is to track the performance of the index, and its low cost -- charging just 0.17% -- ensures it doesn't run up a huge bill for investors. The fund tracks the index almost perfectly, its only difference being its annual expense ratio. It's a good solution for investors who want to own the blue chips without much work.

A third option for investors is to buy a modified index based on the Dow Jones Industrials. Such a fund will have the same 30 stocks, but it will weight them differently from the main index in order to achieve an outcome investors might like better. For example, one of the more recent funds is called the Guggenheim Dow Jones Industrial Average Dividend ETF (NYSEMKT:DJD). This fund weights the stocks to produce a higher dividend yield, and it charges a bit more -- 0.3% -- than the standard fund. However, the performance of this modified fund won't correspond exactly with the performance of the Dow Jones Industrials. Depending on what you're looking for, a modified fund may fit your needs better.

Of course, by investing in funds, you won't be able to enjoy the entire upside of particular stocks that perform really well since your returns will be dragged down by the lesser-performing stocks. Familiarizing yourself with the pros and cons of investing in funds will help.

Should you invest in blue chip stocks?

Blue chips are a great place for beginning investors to dive into the market. Their businesses are already familiar to most people, making it easier to get started analyzing them. These massive market leaders offer investors some of the best business models in the world.

New investors can get started investing in blue chips with limited knowledge by buying index funds, which make it simple and straightforward to capture the growth of the greater market without the skill and time required by a stock-picking strategy.