Investors often sell their winners too soon and hold onto their losers for too long. The reason is simple: They're afraid that their winners will give up their gains, and hopeful that their losers will bounce back. It can be tough to figure out when to cut your losses on a stock, but these 10 questions might help you make up your mind.
1. Has the business fundamentally changed?
As industry trends shift, many companies' strengths become weaknesses. For example, BlackBerry (NYSE:BB) missed a critical technological shift when iPhones and Android devices popularized touchscreen smartphones. That blunder caused its shares to fall nearly 95% over the past decade. If your company is facing a similar paradigm shift, it might be time to rethink your investment thesis.
2. Does the company dismiss its problems?
The reason BlackBerry crashed was that it repeatedly dismissed iPhones and Android devices as viable threats to its smartphone business. Unfortunately for BlackBerry, iOS and Android devices became more secure and widely accepted by enterprise customers -- which caused BlackBerry's market share to drop to nearly 0%. If your company repeatedly dismisses clear threats while touting brand strength or customer loyalty, it may be time to sell the stock.
3. Are revenue and profits headed in the wrong direction?
If a company is still growing its revenue, margins, profits, and cash flows in the face of tough competition, it can probably withstand future headwinds. But if all the numbers move in the wrong direction for several straight quarters, it might be time to sell the stock.
4. Is the company overvalued compared to industry peers?
Another simple way to see if a stock is "ripe" is to check its P/E (price-to-earnings) ratio. For higher-growth stocks, the P/E ratio should be comparable to its annual earnings growth rate. For mature stocks, the P/E ratio should generally be comparable to its industry average. If the stock's P/E ratio is significantly higher than those figures, it may be time to sell.
5. Is the company being pilloried by regulators?
Companies can also be struck down by regulators if they become too powerful. One recent example is Qualcomm (NASDAQ:QCOM), the biggest mobile chipmaker in the world. The company was fined over allegedly unfair patent licensing practices in China and South Korea, and could face additional fines in the U.S., Europe, and other markets. Therefore, if a company is being pilloried by regulators, its upside potential could be limited -- so it might be time to sell.
6. Did management betray investors' trust?
If you don't trust the company's management, don't keep the stock. Toshiba (OTC:TOSBF) and Volkswagen (OTC:VLKA.Y), for example, both betrayed investors' trust recently with two high-profile scandals. A probe found accounting errors throughout Toshiba's massive business, while Volkswagen was implicated in illegally modifying vehicle software to meet emission standards. If a company drops the ball like that, it doesn't deserve your hard-earned money.
7. Does the company lack a competitive moat?
If a company lacks a clear competitive moat against its rivals, its growth will likely slow down as its market is commoditized. That's precisely what happened to GoPro (NASDAQ:GPRO) and Fitbit (NYSE:FIT), which both saw their sales growth slow dramatically due to the arrival of new competitors. If the company repeatedly fails to widen its moat with new products or services, it might be time to sell.
8. Is it a cyclical stock that's moving the wrong way?
Investors should see if the stock is a "cyclical" one that rises and falls on multiyear cycles of higher and lower demand. Common examples of cyclical stocks include car manufacturers and commodity companies. These types of stocks might rally when the cycle turns positive again, but they could also drop further before bottoming out. If you believe that's the case, it might be smarter to sell the stock and buy one with more promising catalysts on the horizon.
9. Did the company unexpectedly cut its dividend?
Dividend cuts indicate that a company's business is in trouble. An easy way to spot upcoming dividend cuts is to keep an eye on a stock's payout ratio, the percentage of its earnings that it spends on dividends. If that ratio is higher than 100% and you own the stock for its dividend, it's definitely time to switch to safer income plays.
10. Is the company's only hope a buyout?
Investors sometimes hope that an 11th-hour buyout will save a dropping stock with abysmal growth prospects. Some of the stocks I previously mentioned -- including BlackBerry, GoPro, and Fitbit -- have all been moved by buyout buzz before. Yet none of those companies has been taken over by their rumored suitors. Therefore, if a buyout is your best hope for a stock's recovery, it's probably time to sell.
The key takeaways
A stock doesn't have to meet all these conditions to justify a sale. But if you answered "yes" to all 10 questions, it's time to cut your losses and sell. The loss will initially hurt, but at least you'll be able to invest the cash into more promising stocks with higher growth potential.