Over the past two years, Vincent Ruggiero of Albertson, N.Y., invested more than $27,000 in Euro Disney, the theme park in France that is 49 percent owned by Disney. Today, his shares are worth about $6,000.
He committed one of the cardinal sins of investing: Riding a stock to the basement because he listened to his heart rather than his head.
“I was pigheaded,” said Ruggiero. “I just loved Disney and couldn’t force myself to sell it.”
Clearly, knowing when to sell a stock is much harder than deciding which one to buy. “Selling is the hardest decision of all,” said Harris Leviton, manager of the $2.7 billion Fidelity Retirement Growth fund.
It’s tough whether you’ve got a loser you hope will rebound or a star performer that’s made you buckets of money.
There are some general rules for when to sell a stock, such as when it reaches preposterous valuation levels or when the reason you bought it no longer applies.
For example, if you bought a stock because you had high hopes for a new product, you should sell if the product is a lemon. Or, if you owned a stock for its high dividends, as many IBM investors did, and the company slashes the payout, that is also a strong signal to sell.
Consider selling if your goals change, you desire a more defensive investment posture, or you want to establish a gain or loss for tax reasons. Also consider selling if a much more attractive opportunity comes along.
When you buy and sell may depend on whether you’re a growth or value investor. A pure earnings-growth investor sells when prices drop. Value investors, who own stocks selling cheaply in relation to earnings or according to other fundamental measures of value, may do the opposite, using a dip in price to gobble up more shares.
By the same token, says Fidelity’s Leviton, it’s not uncommon for a value investor to sell a winning stock that’s gotten too expensive, while a growth investor who thinks the company is in an earnings-growth phase is buying the same issue.
If you are a value investor, keep these five selling rules in mind:
– Target the price. The simplest strategy is to set a target price-say, 30 percent above your buy price-and assess when you hit the mark. Ask yourself whether you would buy the stock today at that price. If the answer is no, sell.
– Target the price-earnings ratio. Lighten up on a stock whose P/E ratio approaches a predetermined target. Some money managers use “trailing” earnings for the previous four quarters to calculate P/Es. For individual issues, trailing P/Es appear in newspaper stock tables. The trailing P/E of the market, as measured by the Standard & Poor’s 500 index, appears each Monday in the Wall Street Journal.
– Target the sector. For certain industries such as banks, thrifts and insurers, a more refined approach is to sell a stock once its P/E ratio equals that of its industry. A good source for industry P/E ratios is Standard & Poor’s Industry Reports ($245 for 12 monthly issues; 800-221-5277).
– Target the cycle. Sell cyclicals-paper, chemical, steel and auto stocks-when their P/E ratios are in single digits. This usually indicates that earnings are near a peak.
– Target the sales. P/E ratios are meaningless for companies that have minuscule profit. In those cases, focus on price in relation to the company’s sales, suggests Michael Murphy, editor of the Overpriced Stock Service.
“Buy when the stock’s market value (share price times shares outstanding) is less than one times sales and sell at two times sales,” said Murphy.
Some growth investors who look for companies with strong earnings momentum argue that it’s virtually impossible to place a fair value on a rapidly growing company. They don’t sell simply because a stock’s P/E ratio is stratospheric. But that approach is especially dangerous for the individual investor, who might own just 5 or 10 stocks and whose portfolio can be devastated if a high P/E stock gets clipped by 25 percent or more in a single day.
Other rules for growth investors:
– Relate P/E to growth. Compare a stock’s P/E ratio to the company’s estimated profit growth over the next few years. Investors normally buy stocks whose P/E ratios are 25 to 50 percent lower than the companies’ earnings growth rates. They sell when that gap disappears.
Because growth investors focus on expectations of future earnings, you should use P/E ratios based on estimates or year-ahead profits. Services that poll brokerage analysts and publish consensus profit estimates and growth rates include Standard & Poor’s Earnings Guide ($135 for 12 monthly issues, 800-221-5277). Another such tool, published by Zacks Investment Research, is Analyst Watch ($249 a year for 24 issues; three-month, six-issue trial, $55; 800-399-6659).
A less costly source for a single firm’s earnings forecast is the Value Line Investment Survey, which is available at many public libraries.
– Sell on earnings disappointments. To a great extent, stock prices move according to how a company measures up to expectations. A company might report a 30 percent gain in quarterly profits, but its stock could still get whacked if most investors expected a 40 percent increase.
You can use the quarterly earnings estimates in the S&P or Zacks’ publications to see how a company’s earnings report stacks up against consensus expectations. If there’s a shortfall, sell-even if the price is substantially lower than before the bad news broke. The rationale for selling quickly is the “cockroach theory,” which holds that one earnings disappointment is likely to be followed by others.
– Watch for speculative excesses. When an entire group of stocks takes off and everyone waxes euphoric about new issues from the same industry, sell. The runup in biotechnology stocks in 1991 had all the earmarks of a speculative bubble. Today’s vulnerable groups: gaming and wireless communications stocks.
Technical analysis can be a useful adjunct in determining when to sell. Anthony Gallea, a broker at Smith Barney Shearson in Pittsford, N.Y., has a simple rule: Sell when a stock’s price drops below that of its 100-day moving average.
To calculate that average, add up the closing prices over the last 100 days and divide by 100. The next day, drop the price from the first day and add the new closing price, and so on. “As long as your stock stays above the moving average, let it ride,” said Gallea. “If it breaks below it, you’re out pretty quickly and you cut your losses.”
Stan Weinstein, editor of the Professional Tape Reader ($395 for 24 bimonthly issues; five-issue trial subscription, $65; 800-868-7857), suggests lightening up on a stock when a big runup is followed by a period of stablizing prices and substantially higher trading volume. This happens, he says, when the latest buyers, who have heard or read about the stock, rush in, but smart investors, including corporate insiders, start to sell.
3 REASONS TO DROP A MUTUAL FUND
1. Managerial changes. “When you pick a fund, you’re buying a manager,” says Kenneth Gregory of the No-Load Fund Analyst newsletters. “If there’s a change in management, you need to reassess.”
2. Fund changes. This could be a change in strategy of asset growth that forces a manager to invest in different kinds of stocks.
3. Underperformance. The toughest call. Some experts don’t worry about a fund lagging its peers unless it’s for more than two years, but Mutual Fund Letter editor Gerald Perritt says one year is long enough: “If you stink relative to your peers, generally you’re gong to continue to stink.”
