When Bad Management Tells You to Sell

Now that it's evident that a magical recovery won't come anytime soon, businesses have started the painful process of trying to adapt to tougher times. In evaluating your portfolio's long-term holdings, you have a front-row seat in seeing how company management deals with the ultimate crisis -- and you should take advantage accordingly.

A tough economy plays havoc on corporate America. In a world where Wall Street wants companies to find ways to improve every quarter, a year or two of bad results can seem like forever, and the gloom builds on itself month after month.

But in deciding which stocks to keep and which to get rid of, you should continue to take a longer-term view. Above all, you need to make sure that the companies you've invested in aren't making decisions that will sacrifice big long-term gains for the sake of short-term results.

Race to the bottom
In the consumer goods industry, you'll find one of the clearest examples of short-term thinking damaging a long-term brand. In 2008, discount vendors like Wal-Mart (NYSE: WMT  ) and Family Dollar (NYSE: FDO  ) for general retail and McDonald's (NYSE: MCD  ) for restaurants outshone their more expensive competitors. Having expended great effort to establish strong reputations for value, these companies cashed in when buying cheaper things suddenly became not only stylish but necessary for many.

Meanwhile, other companies that have suffered from declining demand further up the price chain now look enviously at the success of their lower-end counterparts. The tempting solution for some companies is to abandon their long-term strategy of serving high-end clientele, instead recasting themselves as discounters and banking on their reputations for higher quality to be a competitive advantage.

You've already seen such a response from Starbucks (Nasdaq: SBUX  ) , which has rolled out numerous discount-minded initiatives ranging from value meals to instant coffee. There's no doubt that lower prices make products appealing to a new set of customers.

The real value of a company
The question, though, is whether such initiatives do more harm than good, by potentially alienating longtime loyal customers. Companies like Tiffany (NYSE: TIF  ) and Sotheby's have spent years and millions of dollars cultivating the panache of top quality. Many high-end customers rely on that aura of quality, and it's that investment in image that allows those businesses to maintain fairly high profit margins. Consider:

Stock

Net Profit Margin

Tiffany

9.7%

Sotheby's

16%

Coach (NYSE: COH  )

22.8%

Wal-Mart

3.4%

Sears Holdings (Nasdaq: SHLD  )

0.6%

Source: Yahoo Finance.

Sacrificing that huge investment in order to maintain sales through a downturn could easily prove to be short-sighted and, in the long run, disastrous for a company's survival. Although the bankruptcy of Sharper Image shows that sticking with a failed high-end concept can be fatal, jettisoning years of built-up value for a downturn that, while serious, may not last all that long just looks like more of the panic that we've seen from investors over the past six months.

Make the right call
When you choose a stock, it's incredibly important for you to note the reasons why you believe that stock will do well in the long run. Using Starbucks again as an example, if you bought shares thinking that the company could take on McDonald's and become an all-purpose restaurant success story, then you may think the company's latest moves are a step in the right direction. On the other hand, if you bought Starbucks because you thought that it would do everything necessary to stay a successful high-end coffee seller, then a diversion into the low-end market is exactly what you don't want to see.

Of course, your premise won't always explain why a company does well. It could be that your stock goes up even if it fails to follow through on the reason that made it compelling to you. Nevertheless, as you gain investing experience, you'll soon realize that relying on your instincts is a key part of becoming a smarter investor. When you see company managers doing things you can't support, that's a key sign that you should consider taking your money elsewhere.

For more on investing during tough times, read about:

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Fool contributor Dan Caplinger owns shares of Starbucks but wonders if he should stop ignoring the warning signs. Wal-Mart, Sears Holdings, and Starbucks are Motley Fool Inside Value recommendations. Starbucks and Coach are Motley Fool Stock Advisor picks. The Fool owns shares of Starbucks. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't sell you short.


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