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.
I know, I know… selling all your stocks a few months ago probably would have saved you from significant losses. And indeed, if we'd known what was coming, of course we would have advised selling. But we didn't know, and we don't believe anyone can consistently predict the short-term course of the markets. So we rarely sell great companies.
Still, 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
Now, you won't be able to catch every blowup ahead of time. Few investors were able to divine the troubles that rocked financials like AIG (NYSE: AIG ) and Fannie Mae (NYSE: FNM ) . 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 out for 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, UPS' (NYSE: UPS ) and FedEx's (NYSE: FDX ) 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.
3. An unstable financial model
First, some positive examples: Think of Cisco (Nasdaq: CSCO ) and Oracle (Nasdaq: ORCL ) . 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 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 and selling high. 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 -- their average recommendation is beating the S&P 500 by 24 percentage points. 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.
Fool editor Rex Moore is brought to you by the letter "R." He owns no shares of the companies mentioned in this story. United Parcel Service is a Motley Fool Income Investor selection. FedEx and Amazon.com are Stock Advisor recommendations. The Fool has a disclosure policy.
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