I'm a sucker for behavioral finance studies. Any time I can figure out where and why my potential investment behavior deviates from sound/rational theory, I can take great steps towards improving my own investment strategy by trying to uncover potential areas where emotional can cloud my judgment. One thing I always keep at the back of my mind is the 2012 Dalbar Study which pointed out that individual investors actually experienced returns of 3% annually, even though the S&P 500 marched upwards at over 7% annually from 1991-2011.
A lot of investing errors can be traced to the lurking influence of emotion on our investment decisions, and one area where investors can be particularly susceptible to emotion is when it comes to taking an objective look at an investment that has delivered very nice long-term returns for an investor. If Coca-Cola (NYSE:KO) dividends helped pay to send your kid to college or if you sold off a block of appreciated IBM (NYSE:IBM) stock to make a down payment for a house, it could be difficult identifying a point at which it could possibly come time to sell.
Lately, IBM has been moving in the opposite direction by reducing the outstanding number of shares available as executive compensation from 240 million to around 30 million (as of 2012), but what if it was moving in the opposite direction, threatening the effectiveness of IBM's almost legendary buyback program in the field? How many shares would have to be issued as compensation before you would consider jumping ship? This is the kind of question I'd encourage any long-term investor to ask.
The biggest thing you have to watch out for with stocks that you have held a long time is some combination of (1) changes to the business model, or (2) changes in demand for the product.
I'll use Harley Davidson as an example (NYSE:HOG). For most of the 1990s and 2000s, it could have been very easy for an investor to simply kick back and enter "buy it and forget it mode" with this company. After all, Harley sold an iconic product: the heavyweight motorcycle. The company is the only manufacturer of heavyweight motorcycles in the United States. It has over 1,000 dealerships worldwide. The company's brand is so strong that people actually tattoo "Harley Davidson" across their bodies. It rewarded shareholders with earnings growth and dividend growth seemingly every year. It had many of the trademarks of the perfect stock to hold without serious monitoring.
And then 2009 happened. Harley's earnings fell from $2.79 to $0.06 per share. The dividend got cut from $1.29 to $0.40. What made Harley particularly vulnerable to this past recession in a way that it had not been during the previous two decades? Well, over the past 10-15 years, Harley switched from becoming a motorcycle company to becoming a financial lending company that happened to sell motorcycles. The lending division became almost half of Harley's business by the time the financial crisis struck, and the bad lending practices in the Eaglemark Financial division go a long way towards explaining why Harley's share price fell from $48 in 2008 to $8 in 2009.
Fortunately for shareholders, Harley management acted intelligently to restructure the assets in the lending division and enable the storied motorcycle company to survive the financial crisis and hopefully report earnings this year that eclipse the $2.79 mark earned by the company right before the recession. In many ways, the story at Harley Davidson mirrors the story at General Electric (NYSE:GE) in that both companies were 20th century legends of American enterprise that allowed a financing division to (unsuspectingly to most retail investors?) become such a meaningful component of earnings that it could derail the firm during a time of financial crisis.
Generally, a blue-chip stock does not go from stalwart to dog overnight. In the early 2000s, Eastman Kodak was reporting earnings declines during a time when the rest of corporate America was booming. The company cut the dividend throughout the 2000s, and then finally eliminated it in 2008, a few years before going bankrupt. That does not mean that a company cannot fall fast and hard (just ask Wachovia shareholders how much forewarning they had to monitor the bank's liquidity crisis that brought the firm to its knees), but with non-financial sector investments in particular, we usually get warning signs.
It seems obvious enough to say, but no stock should be above scrutiny. However, applying theory to reality can be difficult when a particular stock has made you a lot of money in your lifetime, particularly if it is a large-cap stock that has traditionally been gilded with "blue-chip status" among the investing public. In particular, I would be wary anytime a blue-chip company takes on its own financing division. If done well, it can be a nice way to augment profits. But taken to excess, it could even take down an iconic American industrial company. The best way to monitor a long-term blue chip stock is to keep a steady eye on changes in the company's sources of profits for signs that the risk profile may be changing.