Most loyal Fool readers know how we feel about selling. If you've found a great company with top-notch management and a strong competitive advantage, the best time to sell is almost never.
But that doesn't mean we hold on blindly. Things change, even with the greatest of companies. That's why we're constantly evaluating our stocks and watching for the danger signs that can torpedo our portfolios.
Today, I'd like to share three rules for selling, as set forth by Fool co-founder Tom Gardner for his Motley Fool Stock Advisor members.
1. Selfish management
Tom calls this the "worst possible development" for any of his companies. If the executive team starts worrying more about lining its own pockets than creating value with the business, it's time to let go. For clues, keep an eye on excessive compensation, active insider selling, declining market share, and aggressive accounting. For me, it comes down to the trust I have in management, and I rarely hold a stock once questions arise. The latest example is the ongoing options-backdating mess, involving past management at such firms as Brocade Communications (NASDAQ:BRCD) and Comverse Technology (NASDAQ:CMVT).
(Just to clarify: The United States government has filed criminal charges against former executives of Brocade Communications, alleging that they engaged in securities fraud resulting from backdating of options, although the federal prosecutors have not alleged that the executives, who have pleaded "not guilty," personally received such backdated options.)
2. Competitive disadvantages
Competitive advantages lead businesses to high returns on capital and equity. They could result from many things -- for instance, the "network effect" advantage enjoyed by eBay (NASDAQ:EBAY), which gives it far more buyers and sellers than any other auction site. This powerful force was underestimated by many investors when first Yahoo! (NASDAQ:YHOO) and then Amazon.com launched their own auction sites several years ago. Though eBay's stock price suffered over fears that these other big names would erode the company's market share, neither could gain much traction, and eBay ran away with the race.
If your company is facing weak pricing power, a declining customer base, and lower market share, it's likely operating at a competitive disadvantage.
3. An unstable financial model
First, let's think of strong companies with stable models, like Nokia (NYSE:NOK) and Ecolab (NYSE:ECL). They're known for stable or rising margins, tight control over working capital, steadily increasing sales, and loads of cash from operations. Companies that aren't following suit in two or more of these categories are showing us a big red flag.
What about valuation?
Obviously, a stock carrying a sky-high valuation is a candidate for selling. But this is the toughest call of all. If properly valuing a company is so easy, after all, everyone would be rich ... happily buying low and selling high. Even Tom has been burned in this area, having sold companies based on valuation, only to watch one or two of them shoot up in value afterward. So tread carefully here; it takes many accurate valuation-based sell calls to make up for just one missed multibagger.
But the three sell signs I've outlined above aren't too hard to spot. Tom and his brother, David, have employed accurate selling and buying guidelines on their way to outstanding performance in Stock Advisor -- 55% total average returns versus 19% for equal amounts invested in the S&P 500. You can get a look at their two picks for new money now, plus all their past recommendations, free of charge with a 30-day trial. There's no obligation to subscribe, and full access to the Stock Advisor service is just a click away.
This article was originally published April 12, 2006. It has been updated.
Rex Moore is brought to you by the letter "R." He owns shares of eBay. Amazon.com, eBay, and Yahoo! are Stock Advisor recommendations. The Fool has adisclosure policy.
