Time to Sell Brocade?

Should you sell Brocade (Nasdaq: BRCD  ) 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 and the recent volatility throughout early August. In this series, 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 Brocade, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Brocade is down 28.1% versus an S&P 500 return of 9.1%. Investors in Brocade 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 Brocade investing thesis. For historical context, let's compare Brocade'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

Brocade

$3.53

$7.30

$10.60

Cisco Systems (Nasdaq: CSCO  )

$15.99

$24.60

$34.20

NetApp (Nasdaq: NTAP  )

$43.42

$61.02

$61.00

Juniper Networks (NYSE: JNPR  )

$22.18

$45.01

$45.00

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

As you can see, Brocade is down from 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 Brocade's gross margin over the past five years:

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

Brocade's gross margin has bounced around, but has stayed within an 8-point range over the past five years. This is solid news; however, Brocade investors need to keep an eye on this over the coming quarters. If margins begin dip again, you'll want to know why.

Next, let's explore what other investors think about Brocade. We love the contrarian view here at Fool.com, but we don't mind cheating off 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 180,000-strong community of individual analysts rate 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)

Brocade

****

3.0

Cisco Systems

****

1.3

NetApp

***

4.8

Juniper Networks

**

2.1

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

The Fool community is rather bullish on Brocade. 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 Brocade's stock pitch page to see the verbatim reasons behind the ratings.

Here, short interest is at a mere 3%. This typically indicates few large institutional investors are betting against the stock.

Now, let's study Brocade'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.

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

Brocade has been taking on some additional debt over the past five years. Even with increasing total equity over the same time period, debt-to-equity has increased. Based on the trend alone, that's a bad sign. I consider a debt-to-equity ratio below 50% to be healthy, though it varies by industry.  Brocade is currently below this level, at 38.3%.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Brocade 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, Brocade has a current ratio of 1.65. 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 Brocade 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 Brocade.

The final recap

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

In order to do that, I strongly recommend clicking here to add Brocade to My Watchlist  to help you keep track of all of our ongoing coverage of the company.

Jeremy Phillips does not own shares of the companies mentioned. The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. 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.


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