Is Hot Topic a Sell?

Should you sell Hot Topic (Nasdaq: HOTT) 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 Hot Topic, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Hot Topic has risen 2.9% versus an S&P 500 return of 13.7%. Investors in Hot Topic 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 Hot Topic investing thesis. For historical context, let's compare Hot Topic'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:

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

As you can see, Hot Topic 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 Hot Topic's gross margin over the past five years:

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

Hot Topic is having no trouble maintaining its gross margin, which tends to dictate a company's overall profitability. This is solid news; however, Hot Topic 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 Hot Topic. 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 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 bearish on Hot Topic. 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 Hot Topic's stock pitch page to see the verbatim reasons behind the ratings.

Here, short interest is at a mere 4.7%. This typically indicates few large institutional investors are betting against the stock.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Hot Topic 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, Hot Topic has a current ratio of 2.71. 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 Hot Topic 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 Hot Topic.

The final recap

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

Remember to add Hot Topic 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.