Check signs for beginning of end for your blue-chip stocks

Many long-term equity investors sleep well, confident in the knowledge that the mature, profitable companies in their portfolios are able to withstand periodic market shocks while fending off competitors. However, since nothing lasts forever, many of these large caps will fade away, possibly within the lifetimes of current shareholders.

The concept of blue-chip mortality presents a challenge for individual investors who favor the "set it and forget it" school of portfolio management. Understandably, they want to minimize churn to contain costs and capture long-term gains, and they also want to manage long-term risk. To reach both goals, they should develop a focused sell discipline to identify which of their big names are starting to show early signs of faltering.

Blue Chips
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Some of these signs are clear from patterns of diminishing performance evident in key metrics that are particularly telling regarding sustainable long-term growth. When these patterns are poor or lackluster, it's time to look for neglectful management, superior competition and disruptions in the marketplace. Investors need to monitor their holdings closely to make sure they aren't hanging on to the next Circuit City, Movie Gallery or Borders. Here's what to look at:

  • Gross margins. If a company's gross or net profit margin is declining over multiple consecutive quarters, this is a sign of trouble. Healthy companies should show a long-term pattern of stable or improving margins.
  • Share price. Look for a trading range in a long-term positive trend relative to the industry and the S&P 500 Index. Is the 200-day moving average keeping pace?
  • Sales/profit/earnings per share. Are sales rising or falling, and how do they compare with the competition? Look at the pattern over three to five years and analysts' projections for the coming year. Do the same with profitability. Compare earnings per share to those of rivals, and keep in mind that a low EPS may be a sign of trouble rather than a bargain.
  • Cash. Most companies have a cyclical flow for their cash. But look at year-over-year and quarter-over-quarter cash flow a year earlier to see if cash is shrinking. Check to see whether the company's current ratio — a measure of a company's ability to pay obligations — is higher than 1.
  • Dividends. A steady dividend payout is good, and increasing dividends are better, as long as the company isn't cannibalizing itself to pay dividends by cutting into its cash or failing to reinvest in new projects. Compare dividend payouts to those of companies in the same industry.
"Investors must stay abreast of changing consumer and business trends, watching for forces that may well push stalwart companies into geriatric decline."

Sometimes, poor readings by such yardsticks foretell potentially terminal corporate illness — the erosion of the corporate life cycle. Such malaise can be spurred by cultural shifts affecting consumer behavior, often involving the impact of advancing technology — historically, the biggest driver of industrial revolution.

Even when the numbers reflect corporate health, companies may be manifestly doomed because of cultural and technological shifts affecting consumer behavior. All too often, they fail to adapt, largely because of the inertia that derives from earning so much for doing the same things the same way for so long. Think RadioShack, Palm, Polaroid — giants in their respective fields felled by technological change.

A good way to watch for fundamental early signs of demise is to periodically ask: Are the reasons that the company exists still relevant today? Because of cultural and technological shifts, will the company's market be there tomorrow?

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Investors must stay abreast of changing consumer and business trends, watching for forces that may well push stalwart companies into geriatric decline. An example is how online retailers are using huge scale and stressing volume and pricing over margins to trump brick-and-mortar retailers.

Investors need to consider the implications of key trends for their portfolios. For example, in the next decade or so, automation and technology is poised to transform transportation — from long-haul trucks and local cabs to possibly car dealers and vehicle makers.

How will this affect your holdings? That's the kind of thinking investors need to engage in to ensure they don't get caught holding an old-school portfolio in a rapidly changing world.

— By Trey Smith, financial advisor at SunTrust Investment Services