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When
to Sell?
You can find plenty of advice about buying stocks, but precious little
about when to sell. To help fill that gap, I'm going to describe three
growth stock 'red flags' that signal that it's time to bail out.
By growth stocks, I mean small to mid-sized companies that are expected
to enjoy rapid sales and earnings growth. Based on my mail, these are
the stocks that interest most readers because fast growth often
translates to big share price gains.
Unfortunately, as the saying goes, "trees don't grow to they sky," and
eventually, growth slows. Maybe a firm saturates its market, or its
success attracts new competition. Whatever the reason, slowing growth
invariably sinks the share price, and your gains can evaporate if you
wait too long to leave the party.
Here are the three 'red flags.'
#1: Declining Margins
The operating margin is the profit a company makes by selling its
products before paying income taxes. For example, a 25%
margin means that the firm makes $25 for every $100 of sales.
The operating margin is more than an arcane accounting figure; it tells
you a lot about a firm's competitive position. To make sales, a company
with less desirable products must charge less than firms that dominate
their markets. Consequently, market leaders are more profitable than the
also-rans.
Although operating margins vary by industry, and within an industry by
time of year, you can get a handle on how a company is doing by
comparing its operating margin in its most recent quarter to the
year-ago figure. Rising margins reflect an improving competitive
position or that the firm is able to produce its products more
efficiently. Both conditions portend continued good times ahead. By
contrast, declining margins vs. year-ago signal that something is going
wrong.
You can use Hoover's (www.hoovers.com)
to see the quarterly operating margins for most firms. Enter the company
name or ticker symbol. From the
Overview report, select Income Statement and then,
Quarterly, to see operating margins going back five quarters.
Compare the most recent operating margin to the year-ago quarter. Small
variations (e.g. 24% vs. 25%) are normal. Consider a 20 percent (e.g.
from 25% to 20%) or greater drop as significant, and thus, a sell
signal.
#2: Declining Forecasts
You can tell a lot about the future by paying attention to changes in
analysts' earnings forecasts. For instance, say that two months ago,
analysts were expecting a company to earn $1.00 per share in 2007, but
now they are only expecting it to report $0.85 for the year. Chances
are, the analysts reduced their forecasts based on actual guidance or
more subtle clues given by the company itself.
In my experience, company management in that situation, even though
they've already hinted at problems, are still overoptimistic. The actual
results will probably be worse than anyone expects.
While many financial sites display the most recent consensus forecasts,
only a few show you historical consensus forecasts going back two or
three months. These include MSN Money (moneycentral.msn.com),
Reuters (www.investor.reuters.com),
Smart Money (www.smartmoney.com)
and Yahoo (finance.yahoo.com).
By the way, consensus forecasts are simply the average of individual
forecasts from analysts covering that stock.
Most sites display forecasts for the current and next quarter, and for
the current and next fiscal year. Pay most attention to the current
fiscal year's forecasts. Consider any significant decline (3 cents or
more) within the past two months as a sell signal. On
Yahoo, you can see the forecast trend data by getting a price
quote and then selecting
Analyst Estimates.
#3: Declining Price Chart
Sometimes, your first hint that something is going wrong is when your
stock's share price falls with no news to account for the drop. Often,
these unexplained downdrafts are triggered by clued-in holders selling
in advance of yet-to-be announced bad news.
That's why growth investors need to keep a close eye on their stocks'
price action. Although no stock goes up every day, growth stocks should
be in uptrends, meaning that they are generally moving up in price. By
contrast, a downtrend means that the stock is mostly heading down. That
can be bad news for all stocks, but especially for growth stocks.
You can determine which way a stock is heading by comparing its current
price to its moving average (average closing price over a specified
number of days). Many investors say a stock is in an uptrend when it's
trading above its moving average and in a downtrend when trading below.
The 50-day moving average typically defines short-term action while the
200-day moving average is often used to assess longer-term trends.
You don't need to read a price chart to see how your stock is doing. For
instance, Yahoo's Key Statistics report (get a
price quote,
then select
Key
Statistics) lists the current price as well as both the 50- and
200-day moving averages.
Ideally, growth stocks should be trading above both moving averages,
signaling a strong uptrend. It's in a downtrend if trading below both
moving averages. Consider that condition a 'sell' signal unless the
stock is reacting to bad news that you know to be of short-term
consequence.
All three of these 'red flags' are equally significant. Sell when you
detect any one of them. Your stock will probably already be off its
high, and you'll be tempted to wait to see if it recovers. Don't! Bad
news usually leads to more bad news.
published 4/29/07 |
