Time to Sell Brocade Communications Systems?

Should you sell Brocade Communications Systems (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. 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 Brocade Communications Systems, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Brocade Communications Systems is down 37.7% versus an S&P 500 return of 11.3%. Investors in Brocade Communications Systems 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 Communications Systems investing thesis. For historical context, let's compare Brocade Communications Systems' recent price to its 52-week and five-year highs. I've also included a few other businesses in the same or related industries:

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

As you can see, Brocade Communications Systems 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 up, we'll get a rough idea of Brocade Communications Systems' valuation. I'm comparing Brocade Communications Systems' recent P/E ratio of 21.6 to where it's been over the past five years.

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

Brocade Communications Systems' P/E is lower than its five-year average, which could indicate the stock is undervalued. A low P/E isn't always a good sign, since the market may be lowering its valuation of the company because of less attractive growth prospects. It does indicate that, on a purely historical basis, Brocade Communications Systems looks cheap.

Now, 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 Communications Systems' gross margin over the past five years:

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

Despite choppy results, Brocade Communications Systems has been able to maintain its gross margin, which tends to dictate a company's overall profitability. This is solid news; however, Brocade Communications Systems 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 Brocade Communications Systems. 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 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.

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

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

Here, short interest is at a high 6.6%. This typically indicates that large institutional investors are betting against the stock.

Now, let's study Brocade Communications Systems' 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 Communications Systems 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, as seen in the above chart. 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 Communications Systems is currently below this level, at 48%.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Brocade Communications Systems had to convert its current assets to cash in one year, how many times over could the company cover its liabilities? As of the last filing, Brocade Communications Systems has a current ratio of 1.50. Brocade Communications Systems could cover its liabilities, but it's still below a healthy level of 1.5.

Finally, it's highly beneficial to determine whether Brocade Communications Systems 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 Communications Systems.

The final recap

Brocade Communications Systems has failed three of the quick tests that would make it a sell. Does it mean you should sell your Brocade Communications Systems shares today solely because of this? Not necessarily, but keep your eye on these trends over the coming quarters.

Remember to add Brocade Communications Systems 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, but sure to read this article detailing how I missed out on over $100,000 in gains through wrong-headed selling.