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, active insider selling, declining market share, and aggressive accounting. A classic example of the latter occurred at Cendant a number of years ago under a previous management team -- which at the time was one of the largest cases of accounting fraud ever.
2. Competitive disadvantages.
Competitive advantages lead businesses to high returns on capital and equity. They could result from many things -- for instance, UPS's (NYSE: UPS ) and FedEx's air distribution systems, or Amazon.com's (Nasdaq: AMZN ) online brand. Though different in nature, these advantages all allow higher returns than most competitors. But if a company in your portfolio is facing weak pricing power, a declining customer base, and lower market share, it's likely operating at a competitive disadvantage. This is not to say that quality competitors such as Barnes & Noble (NYSE: BKS ) can't make gains; indeed, it has done so. But UPS, FedEx, and Amazon continue to have strong competitive advantages.
3. An unstable financial model.
First, let's think of strong companies with stable models, such as McDonald's (NYSE: MCD ) and Tootsie Roll (NYSE: TR ) . 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, selling Whole Foods Market a couple of years ago in Stock Advisor, only to watch it more than double in value afterward. (Whole Foods has since been restored to the ranks of Stock Advisor -- only to fall in price.) So tread carefully here; it takes many accurate valuation-based sell calls to make up for just one missed multibagger.
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 -- 59% total average returns versus 20% 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.
Fool editor Rex Moore is brought to you by the letter "R." He does not own shares of any companies mentioned. Amazon.com, FedEx, and Whole Foods are Stock Advisor recommendations. UPS is an Income Investor selection. The Fool has a disclosure policy.