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 Million Dollar Portfolio, 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 the same store sales growth, rapid store openings, and debt-free position of Chipotle (NYSE: CMG  ) , as our team of analysts does, but at nearly 40 times free cash flow, the valuation says sell anyway. Million Dollar Portfolio sold its shares based on an unfavorable risk-benefit trade-off in its valuation models.

That said, decisions based just on valuation can mislead you sometimes. Netflix (Nasdaq: NFLX  ) has looked rather expensive for years, but it continues 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 has underdone organizational changes and management shakeups, lost its early lead in handheld devices, and taken on debt, all in the past handful of years. Not surprisingly, it didn't create shareholder value before it was finally acquired by Hewlett-Packard.

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. 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. Similarly, if you own either of these stocks today, it makes sense to stay up-to-speed on the health of the housing market. 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  ) . Since 1999, J&J has gained 61% while Merck has lost 48%. That was a great swap.

These are some of the criteria at the forefront of sell decisions at Million Dollar Portfolio. To keep membership manageable, Million Dollar Portfolio will open for a few days this month, the first time members have been able to join since October 2009. Join while you can -- and let us sweat out the tough sell decisions for you. You can get more information about Motley Fool Million Dollar Portfolio by putting your email in the box below.

This article was originally published on June 18, 2009. It has been updated.

Jeff Fischer is the advisor of Motley Fool Pro, and owns no companies mentioned in this article. Lowe's Companies is a Motley Fool Inside Value pick. Chipotle Mexican Grill is a Motley Fool Rule Breakers recommendation. Netflix is a Motley Fool Stock Advisor selection. Chipotle Mexican Grill is a Motley Fool Hidden Gems pick. Johnson & Johnson is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Chipotle Mexican Grill, Johnson & Johnson, and Lowe's Companies. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (5) | Recommend This Article (11)

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 November 03, 2010, at 6:47 PM, lewellen180 wrote:

    Here's another reason to sell:

    You forgot why you bought the stock in the first place. (This speaks to reason 3 in the article.)

    If you don't know why you bought it, you don't know whether you should be keeping it, selling it, or adding to the position when it goes up, down or sideways.

  • Report this Comment On November 04, 2010, at 12:28 AM, shoemaker17 wrote:

    I was lucky enough to buy Chipotle at $42, and I sold at around $185 because I just thought it was way overvalued. Now, the PE ratio is over 40. I started buying shares of Jack in the Box(JACK) because they own Qdoba(which is almost identical to Chipotle). They have a PE of like 13. JACK also franchises some Qdobas, while CMG does not. Am I wrong in my thinking?

  • Report this Comment On November 04, 2010, at 12:34 AM, goalie37 wrote:

    Very good reasons. Since I own stocks for very long periods, it makes sense to come back to these questions on a regular basis. The one that I add is, "With this holding, am I investing or speculating?"

  • Report this Comment On November 04, 2010, at 1:00 AM, topsecret10 wrote:

    Reason one The Federal Reserve Reason Two The Federal Reserve Reason Three The Federal Reserve Reason Four The Federal Reserve !! Sheesh !!!!!!!

  • Report this Comment On November 04, 2010, at 11:59 AM, CPACAPitalist wrote:

    I posted the questions of when to close a position in my CAPS blog several weeks ago and got some great responses from 99+ rated members:

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