In addition to my daily duties with Mind Over Markets, I also serve as managing editor of our premium trading service, Radical Wealth Alliance. For readers of that publication, I've been answering questions all this week about a stock that's under pressure because the company is grappling with internal accounting problems.
The company's competitive position and its products remain inherently sound and shares were soaring before the accounting mess came to light. To those who've asked whether they should dump the stock, I've counseled patience. But it got me to thinking: investors of any type could use a handy guide that explains when to sell a stock.
It's tough to say goodbye. You can get emotionally attached to an investment, just as you can with a person. Sometimes your head tells you one thing, but your heart another.
However, as an investor, you need to listen to your head, and remain coldly rational about your holdings. When a stock starts to head south and the hard data suggest you should sell, don't agonize over it. Sell or at least pare back your exposure. But if the company faces problems that appear to be temporary and the fundamentals remain solid, it's usually wise to hang tough.
Below is a primer on how to tell when the time is ripe to sell. Several other complex factors come into play that are singular to the investment, but these ground rules have the benefit of universal applicability.
Breaking up is hard to do…
If the stock has loyally served you well in the past, you may be reluctant to sell it. But put on your analyst's cap and ask yourself: If I had to rate this stock and I didn't own it, would I give it a buy, sell or hold? If the answer is sell, then follow your own advice.
To make the decision easier, remember that you don't have to dump the entire stock holding. If you think that the stock might decline a bit further but still has long-term potential, at the very least pull back your position.
You might, for example, sell half and put off making a decision about the other half. Nonetheless, don't just hang onto a stock that you've soured on, simply out of inertia or sentimentality.
When first buying a stock, smart investors establish a specific "buy up to" price target or a range within which they would consider selling the stock. As part of every stock purchase, include your own analysis as to what the stock is actually worth.
We tend to look for stocks with a current price that's at a discount to our estimated value. For example, let's say you've set a goal of selling the stock as soon as it has doubled in price-a worthwhile goal that implies that you think the stock is undervalued by 50%.
In addition to monitoring the stock's price, you also should keep an eye on the health of the underlying business. If certain key fundamentals such as revenue, earnings and cash flow markedly decline, you should be proactive and perhaps sell before the stock price takes a dive.
Then there's the so-called "25 percent rule." Historically, the stock prices of strong companies have started to pull back after a rise of about 25 percent. When a stock has reached this threshold, consider locking in at least partial profits.
The Seven Deadly Sins
If your stock has significantly fallen in price, is the decline temporary or is it just the beginning of the end? Scrutinize these seven warning signs. The following list is by no means comprehensive, but it can help you make a determination. If your stock meets one or any combination of these criteria, it's a strong indication you should sell.
1) Quarterly earnings reports show a consistent pattern of missing estimates or losing money.
If the company is consistently missing expectations or running in the red, the stock faces an uphill battle in recovering. It's one thing to experience an earnings miss because of a one-time external factor, but if a trend is emerging that profitability is problematic, the stock probably will have trouble regaining traction.
2) Deteriorating balance sheet.
Increasing debt is an ominous sign. If the company is having trouble getting a handle on ballooning debt, a greater amount of the company's cash flow will get devoted to servicing debt.
Determine whether the company has sufficient cash to satisfy creditors. If a company is imploding, its cash cushion will wane. Soon it won't be able to pay its bills.
A handy indicator is the "cash ratio," which helps you calculate a company's ability to pay short-term debt obligations. The ratio is determined by dividing current assets by current liabilities. A ratio higher than one means that a firm has a solid chance of paying off its debt; below one means the firm probably can't.
Some indebted companies beat the odds and clean up their balance sheets. But poor debt metrics usually spell doom.
3) Analysts' earnings estimates are bearish.
What's the consensus among analysts about future earnings growth? Even if the outlook is mixed, it leaves investors vulnerable to negative earnings surprises. Look for a generally positive outlook from the analysts who cover the stock.
Read This Story: The Earnings Recession…and Why It Matters
4) Reduced or eliminated dividend.
Companies that reduce or eliminate their dividend payments aren't necessarily on the road to bankruptcy. But a dividend cut can be an ominous portent.
If a dividend-paying company you own has slashed its payout, watch for falling or volatile profitability. Beware of an excessively high dividend yield compared to peers. Negative free cash flow is another bad sign.
When investing in dividend-paying stocks, investors need to be mindful of the trade-off between risk and reward. If a company suddenly can't generate enough cash flow to support its dividend, it may cut the dividend or get rid of it altogether.
When judging the merits of a dividend stock, always look for healthy payout ratios, plenty of cash on hand, and earnings growth. These quality dividend payers demonstrate greater resilience during an environment of rising rates and market volatility.
5) A rising short interest ratio.
Short interest is the total number of shares that have been sold short by investors but have not yet been covered or closed out. When expressed as a percentage, short interest is the number of shorted shares divided by the number of shares outstanding.
For example, a stock with 1.5 million shares sold short and 10 million shares outstanding sports a short interest of 15%. Most stock exchanges track the short interest in each stock and issue reports at the end of the month. If short interest is spiking, it's a signal that investors are souring on the stock and it bears closer scrutiny.
6) Increased insider selling.
If corporate insiders are dumping a stock, they know something that the rest of us don't. It's a tip-off that the people running the company realize that the stock is about to under-perform the market. But there's a caveat: sometimes insiders sell for personal reasons that aren't related to the health of the company.
If only one corporate insider is selling, or if the stock has run-up quite a bit, it may simply indicate an individual's desire to pocket profits. But if several corporate insiders are all selling within a short period of time…watch out.
7) The company's products and services aren't distinctive.
If the company provides customers with quality products and dominates its market, it stands a good chance of surviving external shocks that have nothing to do with the core business.
For example, maybe a temporary spike in oil prices is squeezing the bottom line. Energy prices may head back down or the company may find a way to reduce its energy consumption.
Stocks of companies that provide "essential services" tend to be long-term survivors. The world can do without another Starbucks or a faster smartphone. It can even do without Google and eBay. But even in the worst of times, people can't do without lights, heat, health care, or clean drinking water.
Through it all, always remember that diversification is your best defense against the ups and downs of the economy and the markets. Ensuring a well-balanced portfolio will compel you from time to time to sell under-performing investments, to free up your money for better opportunities.
Questions about when to sell a stock? Drop me a line: mailbag@investingdaily.com
John Persinos is the managing editor of Investing Daily.
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