Knowing When to Sell

This is the toughest question every investor faces because buying is relatively easy. There's lots of enthusiasm when you find the stock that seems to have everything. You can't wait to put in the order and watch its meteoric rise. Sometimes it takes off, but sometimes it doesn't work out the way you hoped it would. Any way it goes, though, you have to decide what to do: nothing, buy more, or sell. Let's look at some reasons for selling.

1. The easiest decison to sell some of a stock comes when it's a major winner. It has done even better than you initially imagined. Absolute home run. Maybe a five or ten bagger, as they say on the Street (meaning it went up five or ten times what you paid for it). Hopefully you had the patience to let it do well. When you get a spectacularly performing stock, the last thing you should do is sell it. Don't be afraid of making big money. However, you should be aware of the stock's value in comparison to your overall portfolio. If the stock has taken over more than 10% of your investment dollars, you need to pare it back, say down to somewhere between 5% to 8% of your portofolio. You never want to have too much reliance on any one stock because it can make you very happy when it's going up, but when it goes down, your personality changes. Please note, the recommendation here is not to sell the whole position. In fact, you don't ever want to get out of a strong stock altogether unless it is warranted by fundamental changes in the company. Selling a winning stock because you've made money is like trading Kobe Bryant because you've won too many games. Stay on board your winners for the ride, but don't let them get so influential that any downdraft will alter your personality.
2. Invert your buying process to determine when to sell. Most investors develop a set of criteria for buying a stock: a certain P/E ratio (price to earnings), and/or a Price to Sales Ratio (PSR), and/or profit margins, and/or ROE (return on equity), a low PEG (Price Earnings ratio divided by the Growth rate), etc. You need to constantly monitor these ratios and data points over time, not just when you buy the stock. When a number of these ratios suggest the stock is getting expensive, as determined by your initial valuation, you need to sell the stock. But don't sell if only one of your variables is out of whack. There should be a number of them screaming that the stock is fully valued and that exiting would be the better part of investing.
3. Sell if there has been a dramatic change in the direction of the company. Many times a company will be successful in one business and then decide to enter another. This is usually a real problem. While the original success came from certain skills the management and the workforce possessed, a new area will likely require a different set. A recent example was a very successful company that manufactured airplane safety equipment and then decided to get into the light bulb business. The lights went out for the new endeavor, and the original business, while still prospering, was hurt dramatically by the drain the new business created. Watch out for the new adventures. If they aren't directly leveraging the expertise of the company, get out.
4. Sell if the stock isn't improving earnings. Understand that the accepted valuation of a stock is the discounted value of its future earnings. That means to get a higher price on a stock, it needs to constantly improve earnings, not just match past quarters. However, as an investor, you need to read the earnings announcements carefully and determine if there are one-time charges that are hurting current earnings for the benefit of future earnings. A good example would be the added expense of hiring new sales people. While expensive in the short run, and a hit to current earnings, these additions should add more sales, and more earnings in the future. Some investors don't look at earnings as much as they look at assets of the company, say a film library or real estate holdings, but individual investors usually don't have the acumen to determine these valuations. Stick to the earnings and if they aren't improving over two to three quarters, boot the stock.
5. Sell if you bought the stock for a specific announcement and it didn't occur. Most of the biotech stocks fall into this category. Many of them are on the verge of medical breakthroughs with various diseases. Sometimes the original hopes don't materialize into real medicines. If you buy a stock for an event which is expected and then it doesn't happen, the stock will go down because every one else is selling. Join them or hold the stock and hope. Earnings are better than hope in the stock market.

Many of you will be reading this and asking yourself: what percentage loss should I take before I sell the stock? Sorry, that's not the way to do it. Some investors have certain disciplines: take only a 10% or 20% loss, then get out. Cut your losses, let your winners ride, etc. The only problem with that is that you often get out just as the stock turns around and heads up to new highs. If you have done your homework on a stock, and particularly a small-cap or mid-cap stock (stocks with market values of $100 million to $5 billion), you will experience a great deal of volatility and a 10% or 20% move in the stock is part of the trading day. To simply get out of a stock that you've worked hard to find because it goes down, especially without any news attached to it, only guarantees you'll get out and lose money. Stay with a good stock. Keep up with the news and the quarterly reports. Know your stock well, and the fluctuations every investor must endure won't trouble you as much as the uninformed investor. In fact, many of these downdrafts are great opportunities to buy more of a good stock at a great price, not a chance to sell at a loss and miss out on a winner.