3 Signs Your Stocks May Be in Danger

An earlier version of this article appeared in The Smart Investor website.

One of the secrets to good investing is to regularly check on the health of the companies within your portfolio.

“Buy and Hold” may sound like an attractive proposition, but unfortunately, there are very few stocks that you can just buy and forget.

In an era of technological disruption and rapid change, along with the outbreak of a pandemic, businesses are facing challenges like never before.

Such changes affect businesses in different ways as industries are irreversibly altered.

Take it as a financial health check, similar to what you would do with a regular physical health examination.

By checking in on your investments now and then, you can stay alert to the risks and are ready to react if need be.

Here are three warning signs that can inform you if your stock may be in trouble.

Deteriorating financials

The most obvious sign of trouble is when a company’s financials start to look worse.

To be sure, I am not referring to a temporary decline, but we should be wary of a persistent and irreversible decline.

Businesses do face tough economic conditions from time to time as the economy moves in natural boom and bust cycles.

A temporary decline in revenue and net profit is nothing to be overly concerned about if the economy takes a beating.

But when a business reports worsening numbers even when all is rosy with the world, it’s time to sit up and take notice.

To gain good insights, it’s recommended that you look at trends over a minimum of five years.

Observe important aspects such as revenue, gross margins, net profit, net margins, free cash flow and dividends.

If there is a consistent decline in any of these key attributes, it pays to dig deeper to find out the reason(s).

And if the deterioration boils down to a decline in market share, stronger competition or a permanent and structural change in the industry in which the company operates, it may be time to search for a better alternative.

Falling out of favour

A second red flag would be businesses that are unable to keep up with new or changing trends.

To provide an example, a recent new trend involves healthy living where more people exercise frequently, eschew fatty foods and beverages, and go for plant-based meat products.

Businesses that serve up a portfolio of sugary beverages, such as Coca-Cola (NYSE: KO), would fall out of favour with customers who are planning to switch to healthier alternatives.

On the other hand, plant-based meat specialist Beyond Meat (NASDAQ: BYND) is seeing an increase in demand for its products as more choose to avoid red meat.

When it comes to storage media, the world used to rely on compact discs (CDs) for storage of large, bulky files.

But as technology advanced, CDs fell out of favour and were rapidly replaced by thumb drives, portable hard drives and the cloud.

If you own a business that cannot keep up with evolving trends, it’s a clear sign that falling profits and cash flows may show up soon.

Running just to stay still

A common saying goes like this: change is the only constant.

While this statement may sound clichéd, it’s true of the business world as competitive forces and technological advancements work together to constantly alter the landscape.

External, unexpected events such as the current pandemic may also result in significant changes to the way we work, interact, communicate and be entertained.

What I am referring to here is the ability for a business to adapt.

While change is inevitable, a business that stays nimble and adaptable ensures that it can stay ahead of the pack and end up in pole position.

Conversely, a company that is either unable or unwilling to change may end up running hard just to stay still.

Take the example of e-commerce.

Brands such as Nike (NYSE: NKE) had already established an omni-channel presence that effectively merged both physical and online to offer a seamless customer experience.

Physical retailers hit by pandemic-related store closures were forced to pivot to online selling or risk a plunge in sales.

Companies that could not react fast enough or had not built up a robust online e-commerce system were left struggling.

Get Smart: Assess on a case-by-case basis

These three aspects should be closely monitored to identify early signs of possible business deterioration.

However, it’s also important to remember to look at each company on a case-by-case basis.

Not all instances of decline portend long-term trouble and necessitate a portfolio adjustment.

Judgement should be exercised to determine if the problem(s) can be overcome.

If management seems overwhelmed and is at a loss as to how to react, then it’s time to reassess your investment thesis for the company.

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This article was written by Royston Yang of The Smart Investor.

Disclaimer: Royston Yang owns shares of Nike.