Time to Sell Terra Nitrogen?

Should you sell Terra Nitrogen (NYSE: TNH) today?

The decision to sell a stock you've researched and followed for months or years is never easy. But 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 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 Terra Nitrogen, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Terra Nitrogen has risen 2.5% versus an S&P 500 return of 11.3%. Investors 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 investing thesis. For historical context, let's compare Terra Nitrogen's recent price with its 52-week and five-year highs. I've also included a few other businesses in the same industry or a related one.

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

Terra Nitrogen is basically at its 52-week high, so we need to dig into the valuation to ensure these new highs are justified.

Potential sell signs
First up, we'll get a rough idea of Terra Nitrogen's valuation. I'm comparing its recent P/E ratio of 18.6 with where it's been over the past five years. 

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

Terra Nitrogen's P/E is higher than its five-year average, a possible indication that the stock is overvalued. A high P/E isn't always a bad sign, since the company's growth prospects may also be increasing alongside the market's valuation. However, it definitely indicates that, on a purely historical basis, Terra Nitrogen looks expensive.

Now let's look at the gross-margin 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's Terra Nitrogen's gross margin over the past five years.

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

Terra Nitrogen has been able to grow its gross margin, which tends to dictate a company's overall profitability. This is great news; however, investors need to keep an eye on this metric over the coming quarters. If margins begin to dip, you'll want to know why.

Next, let's explore what other investors think about Terra Nitrogen. 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 portion of our research, 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, and the latter shows what proportion of investors is 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 Terra Nitrogen. We typically like to see our stocks rated at four or five stars. Anything below that level is a less-than-bullish indicator. I highly recommend you visit Terra Nitrogen's stock-pitch page to see the verbatim reasons behind the ratings.

Here, short interest is at a mere 1.6%. A number like this typically indicates that few large institutional investors are betting against the stock.

Now let's study Terra Nitrogen'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.

Terra Nitrogen has had basically no debt over the past five years. That's great news.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Terra Nitrogen had to convert its current assets to cash in one year, how many times over could it cover its liabilities? As of the last filing, the company has a current ratio of 6.12. That's a healthy sign. I like to see companies with current ratios greater than 1.5.

Finally, it's highly beneficial to determine whether Terra Nitrogen 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  adding Terra Nitrogen.

The final recap

Terra Nitrogen has failed only one of the quick tests that would make it a sell. Does that mean you should hold your shares? Not necessarily. Just keep your eye on these trends over the coming quarters.

Remember to add Terra Nitrogen 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.