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When to Sell?

You can find plenty of tips about stocks to buy, but nobody tells you when to sell.

Here are three “red flags” signaling that it’s time to bail out. They apply primarily to growth stocks, which are companies that are expected to achieve strong sales and earnings growth. These are the stocks that interest most investors because, all else equal, fast growth usually translates to big share price gains.

Most investors expect that firms that already racked up strong numbers will continue to grow at the same pace, or even faster.

Alas, that can’t happen. Sooner or later, growth slows. That usually happens when a firm begins to saturate the market, or its success attracts competitors that want to get in on the action. Whatever the reason, news of slowing growth almost always kills the share price. Your gains will evaporate, or even turn into losses if you wait until the word is out before you sell.

Here are the three “red flags.”

Falling 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 tells you a lot about a firm’s competitive position. For starters, companies with less desirable products must charge less than firms that dominate their markets. Also, some firms are able to produce products at lower cost than competitors. For one or both reasons, the best players in any industry record higher operating margins than the also-rans.

Although margins vary by industry, and within an industry by time of year, you can see whether a company’s market position is improving by comparing its recent operating margin to historical values. Rising margins reflect an improving competitive position and vice versa.

You can use Quote.com (www.quote.com) to see quarterly operating margins for most firms. Get a quote and then select the quarterly income statement (Financials menu) 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%  (e.g. from 25% to 20%) or greater drop as significant, and thus, a sell signal.

Reduced Forecasts 
Changes in analysts’ earnings forecasts often predict the future.

For instance, say that two months ago, analysts were expecting a company to earn $1.00 per share in 2010, but now they are only expecting it to report $0.85 for the year. That negative trend tells you that analysts have detected a deteriorating fundamental outlook for the company. Usually, when that happens, the firm’s outlook continues to weaken, and its actual results will be even worse than expected.

You can see the earnings forecast trend on MSN Money (moneycentral.msn.com) in the Consensus EPS Trend section of the Earnings Estimates report.

MSN displays 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.

Declining Price Chart
Many times, a falling stock price triggered by clued-in holders selling in advance of bad news is your first clue that something is going wrong. Thus, it’s important to keep a close eye on your 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.

You can compare a stock’s current price to its moving average (average closing price over a specified number of days) to determine which way it’s trending. It’s in an uptrend when 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 works for assessing longer-term trends.

You can use Yahoo’s Key Statistics report (get a price quote, then select Key Statistics) to see the current price and both the 50- and 200-day moving averages.

Ideally, growth stocks should be trading above both moving averages, signaling a strong uptrend. A stock trading below one moving average bears watching closely. It’s a “sell” signal when trading below both moving averages unless it is reacting to bad news that is 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 3/14/10

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