Should You Sell Smith & Wesson Right Now?

Should you sell Smith & Wesson (Nasdaq: SWHC  ) today?

The decision to sell a stock you've researched and followed for months or years is never easy. If you fall in love with your stock holdings, you risk becoming vulnerable to confirmation bias -- listening only to information that supports your theories, and rejecting any contradictions.

In 2004, longtime Fool Bill Mann called confirmation bias one of the most dangerous components of investing. This warning has helped my own personal investing throughout the Great Recession. Now, I want to help you identify potential sell signs on popular stocks within our 4 million-strong Fool.com community.

Today I'm laser-focused on Smith & Wesson, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Smith & Wesson is down 17.2% versus a positive return for the S&P 500 return of 13.7%. Investors in Smith & Wesson are no doubt disappointed with their returns, but is now the time to cut and run? Not necessarily. Short-term underperformance alone is not a sell sign. The market may be missing the critical element of your Smith & Wesson investing thesis. For historical context, let's compare Smith & Wesson's recent price to its 52-week and five-year highs. I've also included a few other businesses in the same or related industries:

Company	Recent Price	52-Week High	5-Year High
Smith & Wesson	$3.52	$4.71	$22.80
Ceradyne (Nasdaq: CRDN  )	$45.00	$48.99	$84.40
RC2 (Nasdaq: RCRC  )	$27.88	$28.86	$46.20
Sturm, Ruger (NYSE: RGR  )	$21.21	$23.23	$23.20

Source: Capital IQ, a division of Standard & Poor's.

As you can see, Smith & Wesson is well off its 52-week high. If you bought near the peak, now's the time to think back to why you bought it in the first place. If your reasons still hold true, you shouldn't sell based on this information alone.

Potential sell signs
First, let's look at the gross margins trend, which represents the amount of profit a company makes for each $1 in sales, after deducting all costs directly related to that sale. A deteriorating gross margin over time can indicate that competition has forced the company to lower prices, that it can't control costs, or that its whole industry's facing tough times. Here is Smith & Wesson's gross margin over the past five years:

Smith & Wesson is having no trouble maintaining its gross margin, which tends to dictate a company's overall profitability. This is solid news; however, Smith & Wesson investors need to keep an eye on this over the coming quarters. If margins begin to dip, you'll want to know why.

Next, let's explore what other investors think about Smith & Wesson. We love the contrarian view here at Fool.com, but we don't mind cheating off of our neighbors every once in a while. For this, we'll examine two metrics: Motley Fool CAPS ratings and short interest. The former tells us how Fool.com's 170,000-strong community of individual analysts rates the stock. The latter shows what proportion of investors are betting that the stock will fall. I'm including other peer companies once again for context.

Company	CAPS Rating (out of 5)	Short Interest (% of float)
Smith & Wesson	***	3.9%
Ceradyne	*****	4.2%
RC2	***	3.4%
Sturm, Ruger	****	14.5%

Source: Capital IQ, a division of Standard & Poor's.

The Fool community is in the middle of the road on Smith & Wesson. We typically like to see our stocks rated at four or five stars. Anything below that is a less-than-bullish indicator. I highly recommend you visit Smith & Wesson's stock pitch page to see the verbatim reasons behind the ratings.

Here, short interest is at a mere 3.9%. This typically indicates few large institutional investors are betting against the stock.

Now, let's study Smith & Wesson's debt situation, with a little help from the debt-to-equity ratio. This metric tells us how much debt the company's taken on, relative to its overall capital structure.

Smith & Wesson has been taking on some additional debt over the past five years. But when we take into account increasing total equity over the same time period, this has caused debt-to-equity to return to around previous levels, as seen in the above chart. Based on the trend alone, that's a good sign. I consider a debt-to-equity ratio below 50% to be healthy, though it varies by industry. Smith & Wesson is currently above this level, at 86.2%.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Smith & Wesson had to convert its current assets to cash in one year, how many times over could the company cover its current liabilities? As of the last filing, Smith & Wesson has a current ratio of 1.91. This is a healthy sign. I like to see companies with current ratios equal to or greater than 1.5.

Finally, it's highly beneficial to determine whether Smith & Wesson belongs in your portfolio -- and to know how many similar businesses already occupy your stable of investments. If you haven't already, be sure to put your tickers into Fool.com's free portfolio tracker, My Watchlist. You can get started right away by clicking here to add Smith & Wesson.

The final recap

Smith & Wesson has failed just one of the quick tests that would make it a sell. This is great, but does it mean you should hold your Smith & Wesson shares? Not necessarily. Just keep your eye on these trends over the coming quarters.

Remember to add Smith & Wesson to My Watchlist  to help you keep track of all our coverage of the company on Fool.com.

If you haven't had a chance yet, be sure to read this article detailing how I missed out on more than $100,000 in gains through wrong-headed selling.