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 and 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, aggressive accounting, active insider selling, and declining market share. A classic example of this occurred at Tyco (NYSE: TYC ) a few years ago, under former CEO Dennis Kozlowski's watch. (Fortunately, current CEO Ed Breen brings an air of responsibility to Tyco.)
2. Competitive disadvantages
Competitive advantages are what lead businesses to high returns on capital and equity. This could be a result of many things -- for instance, a strong brand. PepsiCo (NYSE: PEP ) and Anheuser-Busch (NYSE: BUD ) can price their products a bit higher than most competitors because they know consumers are willing to pay a few pennies more for a Pepsi or a Gatorade or a Budweiser. These two also have other competitive advantages with regard to economies of scale and supply-chain management. But if your company is facing weak pricing power, a declining customer base, and lower market share, it's likely operating at a competitive disadvantage.
3. An unstable financial model
Let's look at positive examples. Think of eBay (Nasdaq: EBAY ) and 3M (NYSE: MMM ) . They're known for stable or rising margins, tight control over working capital, steadily increasing sales, loads of cash from operations, and a huge surplus on the balance sheet. Companies that are heading in the opposite direction in two or more of these categories are showing 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 were so easy, after all, everyone would be rich ... happily buying low and selling high. Even Tom has been burned in this area, selling Whole Foods Market (Nasdaq: WFMI ) a few years ago in Stock Advisor, only to watch it soar in value afterward. So tread carefully here; it takes a large number of accurate valuation-based sell calls to make up for just one missed multibagger.
But the three sell signs 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 -- 66% total average returns vs. 25% for equal amounts invested in the S&P 500. You can get a look at their two new picks, plus all their past recommendations, free of charge with a 30-day trial. There's no obligation to subscribe.
This article was originally published April 12, 2006. It has been updated.
Rex Moore is brought to you by the letter "R." Of the companies mentioned in this story, he owns shares of Anheuser-Busch and eBay. Whole Foods and eBay are Stock Advisor recommendations. Tyco, 3M, and Anheuser-Busch are Inside Value recommendations. The Fool has a disclosure policy.