Markets

Learning to Say Sell

How to spot the signs that it's time to let go of a stock.

March 16, 2005

If you invest directly in stocks, one of the toughest concepts you'll ever grapple with is when to cut your losses or cash in your gains.

Unfortunately, the psychology of selling can be a wicked game. Says Terrance Odean, a finance professor at the University of California at Berkeley: "Investors don't want to sell when a stock goes down because it closes the chapter of an unhappy event: "I bought, it went down, I sold, I felt lousy." What investor hasn't unloaded a stock only to do a slow burn as it gains another 10% or 15%?

If you've been with a stock longer than you've been with your spouse, it's probably time to reevaluate your reasons for holding it -- and perhaps learn how to say "sell."

Remember, you get a break on capital gains taxes if you've held the stock at least a year (a 15% tax rate for most people). If you're sitting on a loser, there's even a consolation prize: Losses offset capital gains -- from other sales, for example, or mutual-fund distributions -- and, if you have more losses than gains, up to $3,000 of net loss can be deducted against other kinds of income.

How the pros decide

Daniel Bandi, a money manager for Integrity Asset Management, doesn't shy away from shedding losers -- or gainers. He sells at the first sign of bad news about a company. And the quicker, the better. "I've found that if you don't sell right away, what's coming down the pike is usually worse," Bandi says.

Earnings disappointments are another reason to ditch a stock, says Bandi. Bad news is like a cockroach, he says -- you rarely find just one. Disappointing earnings news is often followed by more earnings disappointments.

But not all fund managers are so trigger-happy. Jim Margard, a stock strategist for Rainier Investment Core Equity Portfolio, a large-company growth fund, tends to hold on to the more stable, blue-chip stocks -- unless there's a fundamental change or deterioration in a company's core business.

To Margard, the most important factors that influence whether he sells or sticks it out are a company's competitive position (its market share had better be increasing) and business fundamentals, such as revenue streams, operating efficiency and profits (they shouldn't be deteriorating).

Time to say so long

Both Bandi and Margard agree that the most common mistake individual investors make is to buy a stock for one reason and then hold it for another. Since you can't expect to be as tapped into the market and the minutia of business dealings as institutional investors are, here are some less-taxing tactics to help you figure out when it's time to push the eject button (little or no math required). The principles outlined here aren't terribly technical, but they are fundamental 101 principles that traders too often ignore.

Make a list and check it more than twice. When you buy a stock, write down your reasons for the purchase, says Bandi. Then check up on the company at least once a quarter -- optimally after its quarterly earnings report -- to make sure that your buy rationale still holds true.

If, for instance, you bought a pharmaceutical because you think that its patent on a particular drug gives it an edge over competitors, the company should still have that patent at check-up time. If the patent is in jeopardy, so is investor confidence in the company, and it's time to ditch it.

Gauge the stock's value. One of the simplest reasons to sell is when a stock becomes overpriced. The most familiar measure of value is a price-earnings ratio. The P/E essentially tells how much an investor pays for each dollar per share a company earns. You can compare a stock's P/E with that of the overall market, the average P/E of its industry, or against the company's past P/Es. If the company's ratio is unusually high, it could have a hard time sustaining that price.

A good strategy is to pick a target P/E when you first invest in a stock. If the price jumps but the earnings keep up, you won't have to sell. This method can help give you the discipline to dump the stock before it becomes overpriced. Read Ten Clues to Strong Stocks for more ways to evaluate a stock's value.

Keep an eye on earnings reports. While some managers sell right away if a company misses its earnings target (research firm Thomson First Call polls analysts for consensus estimates), it's probably more prudent to look at the overall earnings trend. Is the company increasing earnings every year? If not, and analysts are lowering their estimation of how much a company can earn in a given quarter or fiscal year, the stock price will likely shrivel with their estimates.

You may want to give companies a little leeway in a recession, but in general, evaporating earnings are a pretty good indication that it's time to get out. Corporate earnings reports also give clues about management's expectations for business in the future. You can see the latest analyst upgrades and downgrades of your stock by entering the ticker in the stock quote box on Kiplinger.com, and clicking on "Earnings."

Check up on cash flow. A cash flow statement gets to the guts of a business -- the cash it receives and the cash it pays out. Some professional investors say cash flow per share gives a clearer view than earnings per share of a company's essential profitability. It's especially handy when researching companies that don't have profits. You can find the information in the company's annual reports, accessible on its Web site. Or you can get annual and quarterly cash flow statements in a Kiplinger.com stock quote. From the stock's overview page, click on "Financials" and then "Cash Flow."

Here's what to look for: Subtract dividend payments and capital spending from operating cash flow, and see if there's anything left. If not, the company doesn't have enough money to maintain its operations (and pay dividends) without borrowing, and it's probably a stock you don't want to own.

Put it on autopilot. It can be especially difficult to pull the sell trigger when a stock falls for no obvious reason, as often happens. A great way to prepare is to place a "stop-loss" order with your broker. This generates an automatic sale if your stock hits the designated price. "A stop-loss order allows you to take emotion out of the game," says Pat Dorsey, head of stock research at Morningstar.

Say you own a stock that sells for $100. Place a stop-loss order at $90 (10% below the price) or at $85 (15% lower if it's a volatile stock). If the stock rises to $110, raise your stop-loss order to $99 (or $93.50 for more-volatile issues). You might give a stock a little more slack if it's falling because the entire market is sinking.

Keep your portfolio in balance. If you went into your stock purchases aiming for diversification, revisit your portfolio once a quarter to see if your holdings are still in balance. If you have one or two big winners and their futures still look bright, you may want to consider taking some profits off the table -- and adding to your other holdings -- just so you won't be overexposed if the unexpected happens. Think Enron.

• Print
• Comments
• Email
• RSS