Most loyal Fool readers know how we feel about selling. If you've found a great company with top-notch management and a strong competitive advantage, the best time to sell is almost never.
But that doesn't mean we hold on blindly. Things change, even with the greatest of companies. That's why we're constantly evaluating our stocks, watching for the danger signs that can torpedo our portfolios.
Today, I'd like to share three rules for selling, as set forth by Fool co-founder Tom Gardner for his Motley Fool Stock Advisor members.
1. Selfish management
Tom calls this the "worst possible development" for any of his companies. If the executive team starts worrying more about lining its own pockets than creating value with the business, it's time to let go. For clues, keep an eye on excessive compensation, active insider selling, declining market share, and aggressive accounting. For me, it comes down to the trust I have in management; I rarely hold a stock once questions arise. The latest example is the options-accounting mess, involving a slew of high-tech firms. Many companies were involved in this, including Trident Microsystems (Nasdaq: TRID ) , Sycamore Networks (Nasdaq: SCMR ) , KLA-Tencor (Nasdaq: KLAC ) , and Juniper Networks (Nasdaq: JNPR ) . If you decide that current management and boards are committed to preventing any such scandals in the future, fine. If not, stay away.
2. Competitive disadvantages
Competitive advantages lead businesses to high returns on capital and equity. For example, Adobe Systems' (Nasdaq: ADBE ) ubiquitous Acrobat PDF format allows Web users to view and print pages exactly as they were intended by the creators. It's the gold standard on the Internet, and the power of critical mass makes it hard for a competitor to gain meaningful market share.
If a company faces weak pricing power, a declining customer base, and lower market share, it's likely operating at a competitive disadvantage.
3. An unstable financial model
First, let's think of strong companies with stable models, like Nordstrom (NYSE: JWN ) and Brown-Forman (NYSE: BF-B ) . They're known for stable or rising margins, tight control over working capital, steadily increasing sales, and loads of cash from operations. Companies that aren't following suit in two or more of these categories are showing us a big red flag.
What about valuation?
Obviously, a stock carrying a sky-high valuation is a candidate for selling. But this is the toughest call of all. If properly valuing a company is so easy, after all, everyone would be rich ... happily buying low and selling high. Even Tom has been burned in this area, having sold companies based on valuation, only to watch one or two of them shoot up in value afterward. So tread carefully here; it takes many accurate valuation-based sell calls to make up for just one missed multibagger.
But the three sell signs I've outlined above aren't too hard to spot. Tom and his brother, David, have employed accurate selling and buying guidelines on their way to outstanding performance in Stock Advisor -- 81% total average returns versus 36% for equal amounts invested in the S&P 500. You can get a look at their two picks for new money now, plus all their past recommendations, free of charge with a 30-day trial. There's no obligation to subscribe, and full access to the Stock Advisor service is just a click away.
This article was originally published April 12, 2006. It has been updated.