By now you may be persuaded that it’s time to consider pruning the most vulnerable stocks from your portfolio. But which ones are they?
Tough question. No one rings a bell when a stock crosses the invisible line from bargain to bloated. Parting with the issues that have made you money–or, for that matter, finally pulling the plug on your mistakes–is one of the most difficult decisions an investor must make.
That’s why professional stock pickers stick to fairly strict rules for cashing in winners and unloading losers. Rules help take the emotions out of the sell decision and eliminate the inertia that can make an investor linger too long in the stock. You’ll find the top pros’ most useful selling guidelines outlined below.
But first, a couple of caveats. Selling a winner may trigger capital gains taxes unless your stocks are stashed in a tax-deferred account or you are in a very low tax bracket. The prospect of having to cut Uncle Sam in on as much as 28 percent of your profits is a good reason not to be too quick to trade your shares. But it shouldn’t keep you from ditching a stock in serious danger of stumbling. After all, a taxed capital gain is better than no gain at all.
A second, more insidious concern is that you may sell too soon. Unfortunately, that could well happen: Most selling strategies are designed to get you out of the stock before the peak. So prepare yourself for the possibility that the stock you just unloaded will continue to soar. Rather than kicking yourself for being too timid, remind yourself that you have preserved profits that you can put into other investments with more promising long-term outlooks.
There are three basic reasons for jettisoning a stock. The most obvious is when the company stumbles badly because of product problems or management errors. You should also consider selling when the reason you bought a stock is no longer valid: The anticipated turnaround didn’t happen, the expected contract never materialized, the announced merger fell apart.
The third sell signal is the toughest to recognize–even though it’s the one that has been flashing most often in today’s robust market. It’s when the shares of a healthy company become fully valued. The definition of “fully valued” varies, however, depending on whether the stock you own is just a growth stock, a value pick or a dividend play.
– Growth stocks. You can spot this flashy crew by their annual earnings increases of 12 percent or more, versus 5.8 percent for the typical stock in the S&P 500. But their stock prices can falter long before their earnings growth gives out.
Indeed, investment adviser Ernest Widmann of Widmann Siff in Bryn Mawr, Pa., cautions investors that analysts often feed the frenzy on hot growth stocks, especially tech issues, by increasing their earnings estimates after each positive quarterly report. Eventually, the analysts raise the hurdle so high that the company could never clear it. Disappointed shareholders then dump the stock with a vengeance.
When the selling starts, it’s often too late for you to get out with your gains intact. So James Craig, manager of the $11.6 billion Janus fund, sells a stock when its P/E ratio, based on the next year’s forecast earnings, is 20 to 25 percent higher than the rate of the company’s sustainable long-term earnings growth.
Michael Murphy, editor of California Technology Stock Letter ($295 annually; 800-998-2875), uses a different yardstick for technology stocks. Because tech firms live or die by their new products, Murphy figures the resources a company devotes to research and development (R&D) are the best gauge of future earnings. So he evaluates companies based on his homespun “growth flow” ratio, the share price divided by earnings per share, plus the amount per share that the company spends on R&D. You can compute these figures from information in the annual report.
Murphy believes companies are ripe for selling when their growth-flow ratios are between 10 and 12.
Another red flag is one or more quarters of disappointing sales or earnings growth. If that happens to a growth stock you own, see if there’s an explanation in news articles or call the company’s investor relations department. Unless the problem is a short-term one–a strike, for example–sell on the theory that earnings disappointments are like cockroaches: If you see one, there are bound to be more.
– Value stocks. Value investors hunt for out-of-favor issues, which are normally characterized by depressed P/Es. To a value buyer, a stock reaches its sell point when its P/E ratio snaps back into line with that of the S&P 500, which is currently 16.9 times the past 12 month’s earnings.
The P/E ratio is not the only tool value investors use, however. Tony Spare, head of the San Francisco investment advisory firm Spare Kaplan Bischel & Associates, invests in corporate giants that pay dividends. So he uses a different measuring stick, buying stocks when their dividend yield is at least 25 percent higher than the market average, recently 2.5 percent for the S&P, and selling when the stock’s dividend yield starts matching the average.
– Dividend stocks. Income investors are partial to steady-Eddie blue chips and utility stocks that have a long history of paying ample dividends and boosting these payouts regularly. The biggest worry here is that a company will stumble and stop raising dividends or, worse, slash payouts. If a company cuts the dividend, you can be sure that the share price will drop, too.
A sign that a company’s dividend may be in danger is a rising payout ratio–the annual dividend per share divided by the yearly earnings per share–which suggests that profits are growing more slowly than dividends.
What’s considered a high ratio varies from industry to industry. But in most cases, says Geraldine Weiss, editor of Investment Quality Trends newsletter ($275 annually; 619-459-3818), a company that routinely hands 85 percent or more of its profits to shareholders has little room to raise dividends if earnings flatten or falter.
You should also be wary if the company fails to raise its dividend as usual. However, don’t dump your share until you find out the reason.
Clearly, selling shares is at least as much of an art as buying them. When Nathan Rothschild of the banking dynasty was asked how he got so rich, he is said to have answered: “I never bought at the bottom and I never sold at the top.” Perhaps the story is apocryphal, but the advice is down to earth.
