As a novice investor you're likely to focus most of your time on what to buy and when. Being a successful investor is as much about knowing when to sell as when to buy. But how do you know when it's time to sell? What are the best reasons to liquidate a holding? Here are a few important basic principles about why and when you should let go of part of your portfolio.
Significant Corporate Structural Problems or Concerns
Every company is going to have peaks and valleys. However, if one of your investments has underlying structural problems, it may indicate that it doesn't have the business "legs" to go the distance. Pay close attention to news about a high turnover rate of its executive staff or Board of Directors, excessive executive compensation (particularly in light of mediocre or poor corporate earnings), questionable corporate ethics, etc. In addition, any company with long-standing, aging leadership should have a clear succession plan in place.
Unexplained Executive Stock Sell-Off
Corporate executives often receive large blocks of stock and/or stock options as part of their compensation package. Periodically they may choose to sell a portion for various personal reasons (i.e. a desire to diversify). However, when several executives at a company sell large blocks of stock it could indicate a lack of confidence in their own company. You can learn what a company's leaders are doing with their stock (if they're buying or selling) because they are required to file documents with the regulators. If they're selling it might be a sign for you to do the same.
Cutting or Canceling Dividends
While a company's decision to cut its dividends doesn't necessarily spell stock price doom, it can raise a red flag. Cutting or canceling stock dividend payouts is a move to conserve cash. The important question is "why?" For example, a company could anticipate needing cash if credit becomes tight during a difficulty economy (i.e. a recession) and choose to cut dividends accordingly. Or it could be a means of preserving cash needed to finance the acquisition of a competitor. However, it could mean that the company has mounting debt that it needs to repay or that it's simply too low on cash to pay out dividends. Do a little digging to learn if the announcement indicates that it's the time to sell.
Inexplicable High P/E Ratio Compared To Competitors
The P/E ratio is a company's stock price compared to its earnings. If a company has an inexplicably higher P/E ratio than its competitors, it means that its stock costs more but is generating the same earnings as lower-priced shares at firms operating in the same market. Companies may have overpriced stock due to investor enthusiasm, and without accompanying earnings results over time, it will unfortunately have no place to go but down. An inexplicably high P/E ratio might indicate that it's time to sell and reinvest with a competitor that has a lower P/E ratio.
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Sustained Decline in Corporate Earnings
Corporate earnings are an important piece of the puzzle known as stock valuation. If earnings are down - and particularly if they stay down - the stock price tends to follow. You'll want to know that little tidbit before you hold on to your investment too long.
Falling Operating Cash Flow Compared to Net Income
Operating cash flow is the amount of cash a company has coming in and how much it pays out within a specific amount of time. Net income is a company's bottom line profit or loss. While a business may be able to show a positive net income on paper, that profit may be in accounts receivable ("AR") and the company could be cash-poor. Without adequate cash it may have to assume debt for financing operations. Debt means the company is paying interest just to operate, and without cash to fund day-to-day obligations, the riskier the company's long-term viability becomes. Watch these two variables to know when it might be time to pull out.
Falling Gross and Operating Margins
Margin is the amount of profit a company makes on a sale. Gross margin is a company's profit on sales before factoring in all costs, such as interest and taxes. If a company's gross margin is falling, that could mean that the company is slashing prices (due to increased competition) or that cost of production is rising and the company can't increase prices to offset it.
A company's operating margin is the company's estimated profit after subtracting costs. Falling operating margin means the company is spending more money than it is making. A combination of sustained falling gross and operating margins may mean the company is having a difficult time of managing costs and/or its product price point. Either way it could mean that it's time to sell.
High Debt-to-Equity Ratio
A high debt-to-equity ratio means that a company is carrying significantly more debt than it has in shareholder investment. If the ratio is greater than one, the company is operating more on the basis of debt than equity. It's important to know the generally acceptable debt-to-equity ratio for companies within an industry before you respond to a high number by dumping a stock. However, if the ratio continues to climb over time without explanation - and especially if the ratio is excessively high beyond either competitor or industry standards - it might be a signal to sell.
Sustained Increase in Corporate Receivables Compared to Sales
A company's accounts receivables is how much it has billed out and is waiting to be paid. There are a few reasons that receivables begin to climb:
- Clients/customers are in a cash crunch and are taking longer to pay their bills than in the past
- A company is falling behind in getting bills out
- A company has chosen to extend its payment due dates to accommodate customers' financial strain or as a financial benefit to entice customer sales and/or loyalty
You can gauge a company's receivables compared to sales by reviewing its quarterly income statement and comparing the receivables (balance sheet) ratio to sales (income). Always compare numbers during the same period (i.e. a certain month or quarter) from one year to the next. If the company has sustained prolonged payment delays it could begin to erode its stock price.
Significant Market Shrinkage Or Product Commoditization
If a company holds a small percentage of its market and that overall market shrinks, it will need to quickly adapt to the new market fundamentals and innovate to establish a stronger position. If a company's competitors have quickly replicated its product and driven down the cost, the game has changed. If it's not the lowest-cost producer or it doesn't have significant brand strength to charge higher prices for a product (i.e. Starbucks for coffee), it will need to respond quickly. Pay attention to the market trends for the companies in your portfolio and make sure that they have strong, effective responses to market shrinkage or product commoditization or your investment is ultimately what will shrink in value.
Hostile M&A Bids
Financially healthy, aggressive companies regularly look for opportunities to grab a larger share of the market. If you own stock in a company that is the object of one or more hostile takeover bids it could mean that it is viewed as financially weak and a good "buying" opportunity for a larger entity. The problem is another company's gain could be your loss. Watch potential acquisition movement carefully.
The Bottom Line
It's important to have a strategy for both buying and selling stock. While you may have personal reasons for choosing to liquidate a holding (i.e. you have an unexpected financial need, the company's stock price has hit your personal target sell price, etc.) there are also corporate signals to watch for to determine if it's the best time to get out. Review quarterly reports for signs of trouble instead of waiting to be surprised by dramatic headline news or a sudden drop in stock price. If you're unsure about what types of conclusions to draw from company financial statements or portfolio reports, consider working with a credible, reputable financial professional.