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, with the global markets roiled by the credit crunch, the topic of when to sell is more important than ever. Here are three rules for selling, as set forth by Fool co-founder Tom Gardner for his Motley Fool Stock Advisor members.
1. Selfish or inept management
Tom calls this the "worst possible development" for any of his companies. Now, you won't be able to catch every blowup ahead of time; not many were able to divine the troubles that rocked financials like Citigroup (NYSE: C ) and Washington Mutual (NYSE: WM ) . But there are some things you can see. 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.
2. Competitive disadvantages
Competitive advantages lead businesses to high returns on capital and equity. They could result from many things -- for instance, Wal-Mart's (NYSE: WMT ) superior distribution system or Intel's (Nasdaq: INTC ) economies of scale. Though different in nature, these advantages 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 Target and AMD (NYSE: AMD ) can't make big gains; indeed, each has done so. But Wal-Mart and Intel continue to benefit from these positives.
3. An unstable financial model
Good businesses tend to have stable or rising margins, tight control over working capital, steadily increasing sales, loads of cash from operations, and a solid balance sheet. IBM (NYSE: IBM ) and Johnson & Johnson (NYSE: JNJ ) are a couple of examples. 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 was so easy, after all, everyone would be rich ... happily buying low, selling high, and eating caviar. The problem is that stellar businesses can sometimes seem overvalued by traditional measures, yet continue to roll up big, multi-year gains. 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 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 -- with total average returns easily outpacing the S&P 500. You can get a look at their top five stocks for new money now, 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.
Stock Advisor analyst Rex Moore is brought to you by the letter "R." He owns shares of Johnson & Johnson. Johnson & Johnson is a Motley Fool Income Investor selection. Wal-Mart Stores and Intel are Inside Value recommendations. The Fool has a disclosure policy.