Time to invest in blue-chip stocks

As stock volatility returned in August and September following a long lull, one of the market trends I identified was the disproportionate selling of some of the largest and most defensive blue-chip companies. If this seems counterintuitive to you, then you're not alone.

In times of increasing market volatility, one would expect money to flow into those companies best able to: 1) protect their revenue and earnings streams; 2) self-fund operations; 3) pay a competitive dividend yield; and, of course, 4) avoid financial distress. But this year I really haven't seen that flight to quality.

Traders work on the floor of the New York Stock Exchange.
Getty Images
Traders work on the floor of the New York Stock Exchange.

Instead, I've seen a continued preference for those companies that offer superior growth prospects. As we all know, though, outsized growth and returns come at a price, and that price is greater risk and volatility.

Some high-growth stocks that have performed exceedingly well in the past few years include: Tesla, Netflix, Facebook, Under Armour, Salesforce, LinkedIn and Amazon. On average, these stocks are up well over 400 percent since the end of 2011. At current prices, these companies are now worth a combined $754 billion(!) and trade at an average price-earnings multiple of 127 times. The growth had better materialize or there could be some sizable corrections in names like these which, importantly, make up an increasing percentage of the major indices like the S&P 500.

Source: Bloomberg and Thomson Reuters

So why are investors hoarding high-growth stocks that have already generated huge gains while continuing to shun defensive blue chips? It would seem that at this stage in the market cycle, following 6 plus years of strong market gains and on the eve of a tightening campaign by the Federal Reserve, investors would be doing quite the opposite. Well, I can think of a number of reasons.

  • An increasing number of "investors" are operating with a trader's mentality, content with following momentum rather than investing for the long term. Moreover, there is strong reluctance to part with the high-growth companies that have yielded tremendous investor gains during the course of this bull market. In short, they've fallen in love with their winners, which can be one of the most fundamental investor pitfalls.
  • During the initial stages of a volatile market, professional investors, both passive and active, may opt to sell their most liquid holdings first in order to meet redemptions from anxious investors. These tend to be the higher-quality and more defensive stocks.
  • Many investors may not want to sell stocks that have done extremely well because they want to avoid sizable capital-gains taxes.
  • The U.S. is arguably the best-performing major economy in the world right now, and with less systemic risk thanks to the successful recapitalization of the banking system. Investors are hopeful that capital will continue to flow into the U.S. from overseas, supporting lofty valuations for high-growth companies.
  • Investors are willing to pay a high premium for growth because the weak global economic backdrop offers very few opportunities for strong growth.
  • And perhaps most importantly, investors have been conditioned to expect strong Fed support upon any market swoon. The Fed's about-face on an initial rate hike in September was further confirmation that the central bank remains willing to act in order to limit stock-market losses.

At the same time that investors chase high-flying market darlings, there is a glut of high-quality and defensive blue-chip stocks that have underperformed this year despite their reasonable valuations, including United Technologies, Qualcomm and Johnson & Johnson. What's more, many of these companies are carrying huge stockpiles of cash and offer dividend yields well in excess of the 10-year Treasury bond. My question then is, given the market/economic backdrop, would you feel more comfortable owning a basket of stocks with these characteristics or the basket of stocks listed in the table above for the next five years?

I think the choice is clear. Now is no time to swing for the fences.

After almost seven years of a bull market, investors forget the pain of past plummets. They become less concerned about risk because they haven't had to endure any significant consequence or pain for a long time. After long uptrends, investors focus on the gains they may be missing and not on the principal that they were not long ago desperate to protect. We have seen these patterns before and know that while these conditions may last a lot longer than most expect, they will change, and the greedy will suffer. Be cautious, disciplined, dispassionate, and wise. Do your research, and think about the advice that your grandparents would offer; you'll know exactly what you should be doing!

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.

Disclosure: Michael Farr and Farr, Miller & Washington own shares of United Technologies, Qualcomm and Johnson & Johnson but none of the other stocks mentioned in this article.