4 Reasons to Sell a Stock

The hope of profits and the joy of ownership make buying stocks a fairly simple decision, especially in comparison to the tormented hair-pulling that's often associated with selling.

When to jettison a stock is a difficult decision, so we won't pretend there's a one-size-fits-all formula. However, guidelines can make selling decisions easier. At Motley Fool Pro, the following are four key factors in any sell considerations.

1. Valuation
The most cited reason to sell -- a fairly valued stock -- is also the most difficult to nail down.

We estimate the fair value of a company before plunking money down to buy, determining intrinsic value by digging into financial statements, analyzing business prospects and free cash flow, and making conservative assumptions about future growth.

Buying undervalued stocks, we wait patiently for a price that's close to our estimate of fair value, reassess at that point, and then ruthlessly sell if the stock looks fairly priced. One challenge is overcoming your attachment to the stock -- everyone loves a winner -- and the dream that it will go up indefinitely. You may love everything about a business, but if its stock is trading for more than 100 times earnings estimates, the valuation says sell anyway.

That said, decisions based just on valuation can mislead you sometimes. Netflix (Nasdaq: NFLX  ) looked rather expensive for years, but continued to reward shareholders. If valuation on a leading business is perplexing you, you may consider selling just some of your shares (to lock in profits) or protecting your gains through other means (including options), and then consider other factors that may influence a sell decision.

2. Fundamental change in the underlying business
Companies are always undergoing change -- sometimes for the better, oftentimes not. As patient investors, we're willing to tolerate minor, fixable hiccups along the lines of a weak quarter or delayed product launch. We're not so forgiving of major blunders -- think acquisitions that undermine the core business, getting surpassed by a competitor, taking on unproductive debt, or a string of failed new product attempts. Whenever a business undergoes a significant change, you need to put on your thinking cap and reassess.

Palm underwent organizational changes and management shakeups, lost its early lead in handheld devices, and took on debt. Not surprisingly, it failed to create much shareholder value before being acquired.

3. Challenges to your investing thesis
When you make a buy decision, you should write down your reasons and keep them handy. Knowing the most important drivers behind your buys, you can reassess your decision if any part of your thesis is challenged.

Because valuation is part of any thesis, threatening changes can include dividend cuts, deterioration of margins, weakening free cash flow --- or economic shifts. At Pro, we keep the big picture in mind. If you'd bought Lowe’s (NYSE: LOW  ) or Brookfield Homes (NYSE: BHS  ) before 2007 believing a housing boom would continue, you'd have followed housing news closely and may have seen your thesis falling apart -- forcing a timely sale. So, what's the thesis behind each stock you own? Write it down.

4. Better places for your money
Sometimes a sell decision has little to do with the holding itself -- you may simply see better opportunities elsewhere and lack the funds to take advantage. Just as a soccer coach will swap tired players for fresh ones in order to win the game, your portfolio can benefit from shuffling some players, too.

In the late 1990s, it was becoming apparent Johnson & Johnson (NYSE: JNJ  ) had a better business model than the pure drug companies, including Merck (NYSE: MRK  ) . From 1999 to the end of 2009, J&J has gained 42% while Merck has lost 41%. That was a great swap.

Just like the five traits of great stocks we keep in mind when we buy, these are some of the criteria at the forefront of our sell decisions at Motley Fool Pro.

Jeff Fischer is advisor of Motley Fool Pro and Motley Fool Options. He doesn’t have positions in any companies mentioned. Netflix is a Motley Fool Stock Advisor selection. Lowe’s is an Inside Value recommendation. Johnson & Johnson is an Income Investor selection, and Motley Fool Options has suggested calls on J&J. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 24, 2010, at 7:40 PM, MDForever wrote:

    PALM is a poor example, seeing that it has risen almost 9 fold since 12/08.

  • Report this Comment On January 25, 2010, at 9:49 AM, lotontech wrote:

    You missed a fifth reason to sell:

    5. The price is falling! (in which case your well-placed Stop Order should get you out automatically)

    I know, it's not the "Foolish" way.

  • Report this Comment On January 25, 2010, at 11:13 AM, TMFFischer wrote:

    Greetings,

    Regarding Palm, it depends on your time horizon, of course, but over the bulk of its life, it hasn't yet created shareholder value. That said, it's young still and it has plenty of time to succeed if it's going to (for the people working there, you hope the best).

    But since 2000, like most stocks, it is down sharply (PALM is down more than average since then, some 90% according to Google Finance). Since 2005, it is down, as well. In the last year, of course PALM has rebounded, but it's still down the last 5 years.

    Selling because a price is falling: I'd disagree. When we're talking about good companies, you want to be buying when stocks are falling to an attractive price. If you already own, you most likely need to wait for a rebound and/or should add more to your favorites. Even immortals like Warren Buffett suffer quotational losses and wait them out. But if you use stop-losses on your stocks, you'll often be stopped out on mere price volatility and too often won't be able to get back in before prices go up again. Stop-losss have their place (on stocks that you really would want to sell if they started to fall), but using stop-losses on all of your long-term stocks is ultimately a recipe for disappointment, IMO.

    Best,

    Jeff

  • Report this Comment On January 26, 2010, at 11:12 PM, jakerome wrote:

    Take a look at Palm since they started to redefine their company with the Treo in late 2003. And keep in mind that they essentially split when they paid a $9 dividend a couple years ago.

    Obviously, they are far off from their dotcom peak, but let's face it, Motley Fool has fallen just as far from their perch since then as well.

  • Report this Comment On January 26, 2010, at 11:14 PM, automaticaev wrote:

    you sell the stock after your plan works....

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