With Nvidia Replacing Intel in the Dow Jones, Is It Time to Redefine What It Means to Be a Blue Chip Stock? | The Motley Fool

The Dow Jones Industrial Average (^DJI 0.59%) is making its second major change in 2024. Earlier this year, Amazon (AMZN -0.89%) replaced Walgreens Boots Alliance. Now, Nvidia (NVDA -0.84%) is swapping with Intel, and Sherwin-Williams is replacing chemical giant Dow.

Here’s why the shakeups in the 128-year-old index reflect broader market leadership, and why the very definition of what it means to be a blue chip stock could need an update.

In with growth, out with high yield

The term “blue chip” comes from poker, where it refers to the highest chip denomination. There is no official definition of a blue chip stock, but traditionally all 30 components of the Dow would make the cut, as well as companies that have increased their dividends for an extended period of time, such as Dividend Kings. Dividend Kings are companies that have grown their dividends for at least 50 consecutive years.

Most, but not all, Dow stocks pay dividends. In August 2020, Salesforce replaced ExxonMobil in the Dow. It became the third component not to pay a dividend, after Boeing and Walt Disney suspended their quarterly payouts earlier in the year. However, Salesforce began paying a modest dividend earlier this year, and Disney has since brought back its dividend, at a smaller amount than before the cut.

Amazon doesn’t currently pay a dividend. Nvidia does, but only on a technicality, as it is just $0.01 per share per quarter. Sherwin-Williams yields just 0.8%, whereas the company it’s replacing, Dow, was one of the highest-yielding companies in the index, with a yield of 5.7% at Friday’s prices.

Post-adjustment, there will be just 16 Dow components that yield 2% or more, and eight components that yield 1% or less.

In the past, the Dow was chock-full of companies that prioritized dividends. Today, the focus has shifted away from dividends toward industry leadership.

Understanding dividends and capital allocation

To understand why dividends are so fundamental to our image of a blue chip stock, we have to first understand why companies pay them in the first place.

A dividend is a way for a company to pass along earnings directly to its shareholders. If it can pay a dividend consistently over the long term, its business is probably solid. If a company can raise its dividend every year, that implies earnings are growing, so it can afford to pass even more profits to shareholders.

However, dividends are just one way a company can allocate capital. A company can pay down debt or keep excess earnings in cash and cash equivalents or marketable securities. It can also repurchase stock, which reduces the share count and artificially increases earnings per share. It can engage in mergers and acquisitions (M&A), and companies can pour money back into the business to drive organic growth.

Many of the traditional blue chip Dow stocks have limited growth prospects or business models that actually don’t need ever-higher levels of reinvestment. For example, Coca-Cola shareholders wouldn’t want to see the company use all its excess profits in risky research and development endeavors in the hopes of making the next great soda. It would be unwise for Procter & Gamble to throw money at the wall in the hopes of developing a game-changing paper towel. Even a company like JPMorgan Chase would prefer steadily growing its network and client base rather than overleveraging and jeopardizing its stability. So naturally, these companies use dividends as a key way to reward shareholders with passive income, no matter what the stock market is doing.

In comparison, today’s most valuable companies are mostly considered growth stocks. Dividends may be part of the equation, but they aren’t the focus. Apple and Microsoft pay dividends, but both yield less than 1%. Alphabet and Meta Platforms began paying dividends earlier this year, but both yield less than 0.5%. However, a common theme among all these companies is that they buy back a considerable amount of their own stock.

Using capital to buy back stock instead of paying a dividend shows confidence that management believes the stock is a good value and will produce a better return than dividends over time. So far, that strategy has certainly proven true for mega-cap tech giants like Apple, Microsoft, Alphabet, and Meta, which have crushed the performance of the broader market over the long term.

Warren Buffett-led Berkshire Hathaway famously doesn’t pay a dividend, because Buffett believes Berkshire can provide a higher return to investors with capital gains than dividends (and he’s been right). Despite its lack of dividends, many folks would probably consider Berkshire Hathaway a blue chip stock. The same goes for Meta and Alphabet, even though they sport such low yields and have been paying dividends for a matter of months rather than decades. But what about companies that don’t sport sizable dividends or buyback programs?

Recent Dow additions Amazon and Nvidia dilute their shareholders with stock-based compensation. Amazon, in particular, is famous for pouring money back into the business to invest in a variety of industries. Over the last decade, Amazon’s share count has increased by 13.1%, but the stock price has increased by over 13-fold. So it’s hard to argue against Amazon’s ultra-aggressive capital allocation strategy.

A new take on blue chip stocks

The Dow Jones Industrial Average has evolved, and so should the definition of “blue chip stock.”

Blue chip status should be more about industry leadership and the effectiveness of capital allocation, rather than discriminating based on whether capital is allocated toward dividends, buybacks, M&A, or organic growth. That being said, if a company decides to go the riskier route of companies like Amazon or Nvidia, it needs to prove that the capital spending is worth it.

The term “blue chip” should be reserved for industry-leading companies that generate plenty of excess capital and use it in a way that maximizes shareholder value.