Better Investing Magazine, July 2006
Selling a stock is rarely an easy decision. When discussing their biggest problems, readers often mention knowing when to sell as their No. 1 issue.
In a two-part series, volunteer BetterInvesting educator Colleen Mulder-Seward discusses the sell process. This month's article is a brief overview of what to do before selling a stock along with a summary of the eight reasons for doing so. The material is adapted from a seminar Colleen developed. Readers also might want to refer to Ken Janke's "Mr. NAIC" columns between October 2005 and February 2006 for additional thoughts on selling.
Sell and hold decisions are rarely easy, and often there are no right answers. Sell decisions are apt to be less serious and frequent if stocks are carefully selected. Remember that everyone makes mistakes, but wise investors learn from them.
Although you might be a long-term investor, "buy and hold" doesn't mean "buy and forget." Over time, a company's management and its industry are likely to change. The political climate and economy also change. You might also find that your original stock study had overly optimistic assumptions. In any case, you'll need to adjust your original study.
Before selling a stock, you'll want to complete a stock study of it. The primary stock-study tool of BetterInvesting members is the Stock Selection Guide, and the following guidance relates to some of the key judgments you'll need to make.
Create an optimistic SSG when considering a stock for sale. You're creating an optimistic stock study when deciding whether to sell -- as opposed to a more conservative study when deciding whether to buy -- to help you avoid selling a stock too soon.
Don't arbitrarily set sales and earnings growth rates that are lower than historical trends. When determining the high price-earnings ratio, which helps you forecast the potential high price for a stock, don't use an automatic limit. (Editor's note: Many investors like to limit the high P/E to a certain number -- 30, for example.) Also, use a projected earnings per share, not the current EPS, in determining the stock's potential low price.
Setting Growth Rates
Two key judgments are forecasting the sales and earnings growth rates. The graph on this page shows the historical sales and earnings growth rates for Johnson & Johnson. (No recommendation is intended. Readers are urged to conduct their own stock studies using their own judgments. The data for J&J isn't current.) In the graph, the sales growth rate going back two years, for example, is 13 percent; for four years, the rate is 11 percent.
Johnson & Johnson has been able to increase its growth rates over the past 10 years. When doing a "buy" SSG for J&J, you would probably use the average growth rates of the past five or 10 years. So for the sales growth rate, you might be inclined to forecast a rate of about 11 percent if you're using the 10-year growth rate as a guide. For the earnings rate, perhaps you would forecast a rate somewhere around 15 percent.
But if you're preparing a "sell" SSG, using these rates might lead you to sell the stock too soon. Instead, try using the two-year average for stocks with increasing growth rates. The sales rate in this case might be about 14 percent; earnings, around 17 percent.
You also can employ analysts' consensus estimates for EPS growth. Analysts tend to be optimistic, however, so you probably want to make sure your growth rate is in the analysts' range.
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Setting P/E Ratios
Follow the same thought process when setting high and low P/Es. When doing a "buy" SSG, a conservative estimate of J&J's high P/E, derived by eliminating five of the past 10 years' high P/Es, might be about 24 (see table, this page). After eliminating outliers for the low P/E -- I threw out the numbers for 1996-1999 and 2001 -- you might select a low P/E of about 16.
For a "sell" SSG, you want to be optimistic. For the high P/E, you might consider as outliers only 1994, 1998 and 1999, leading to an estimated high P/E of about 28. For the low P/E, you might consider as outliers the same years, for an estimated low P/E of around 19.
Another suggestion to help you avoid selling too soon: When doing a "buy" SSG, people often use last year's earnings for the estimated low EPS in forecasting the stock's potential low price. Instead, consider using the projected EPS for the next four quarters. This will raise the estimated low price.
Better Investing Magazine,
August 2006
by
Colleen Mulder-Seward
Editor's note: This is the second part of an article on the thought
process of selling a stock.
There is really no time to sell; there are only reasons to do so. The eight main reasons to consider selling a stock are:
This month we'll focus on the first three reasons because these are the most difficult to understand and occur most often.
Deteriorating Fundamentals
The first signs that a company's fundamentals are deteriorating will show on a visual inspection of a company's sales and earnings per share growth history. You can see this on the first page of the Stock Selection Guide, the main stock-study tool of the BetterInvesting community. The trailing 12-month (TTM) growth rates for sales, EPS and profit margins also will be slowing down.
Any downward trend in growth rates is a sign of deterioration. The image on this page shows the growth history for Valassis Communications, Inc., with sales in green, earnings in blue and pre-tax profits in magenta. Notice that the highlighted data points are lower than the previous years' numbers. This shows a slowdown. Likewise, the company's trailing 12-month growth rates for sales, EPS and pre-tax profits have decreased.
(Editor's note: Since the graphs for this article are for educational purposes only, they may not have up-to-date data. No investment recommendation is intended for any of the companies mentioned in this article.)
Increasing debt is another serious sign of deterioration that must be investigated. This is a concern because the more debt a company takes on, the more money it needs to take from earnings just to service its debts. Too much debt leaves a company vulnerable during lean times. Many people believe more than 33 percent of debt is cause for concern. There are exceptions, however, such as companies in the homebuilding industry.
Determine whether inventories or accounts receivable (money owed the company for products and services already purchased) are increasing. Rising inventories can indicate a problem because it might mean products aren't selling. Therefore, the company may have to resort to reducing prices or write off the inventory completely, either of which will affect profit margins and EPS.
A rise in accounts receivable can indicate the company isn't able to collect the money due from its customers. The company may have to resort to using collection agencies, which adds expense, or write off the amount due. Both of these options affect profit margins and EPS.
The final indicator of deteriorating fundamentals we'll consider is decreasing or negative cash flow. Investopedia defines cash flow as "a revenue or expense stream that changes a cash account over a given period." Cash flow is crucial because ample cash on hand ensures that the company's creditors and employees can be paid on time.
If a company's cash flow is weak, there's a chance it will face bankruptcy in the future. On the other hand, companies with a positive cash flow are able to invest the cash back into the business and use it to generate more cash and profit. If you ever encounter negative numbers, it might be time to sell. (Editor's note: Make sure you understand why a company's cash flow is negative; sometimes it means the company is investing in long-term growth. For more information on cash flow and other terms discussed in the previous paragraphs, refer to the magazine's May, June and July issues.)
Unfavorable Company Changes
Many changes can take place at a company that hurt it. The first is a change in management. It's especially noteworthy when a chief financial officer resigns unexpectedly. Although the departure might not be significant, it sometimes can indicate accounting irregularities. Another problem is when several key executives leave; it often takes companies years to recover from the loss of several executive-level managers.
A significant increase in competition likely will affect profit margins. When a new competitor enters the marketplace, the original company often will have to lower its prices to stay competitive. Lower prices usually equate to lower profit margins and EPS.
Companies that rely heavily on research and development (R&D), such as pharmaceutical companies, can be severely affected by declines in its pipeline of new products. What happened to Schering-Plough Corporation (SGP) is one example. When the patent for Claritin held by Schering-Plough expired, the company's pre-tax profits (or PTP, the magenta line in the graph on this page) and EPS (the blue line) were severely affected. The stock price also collapsed, as shown by the black vertical lines on the graph that resemble capital I's.
Retail stores are best evaluated by tracking their same-store sales. A declining same-store sales rate is a bad sign. It means the company's customers aren't purchasing as much as they once did. This could be because the company's brand is falling out of favor.
A worsening product mix can lead to a decrease in profits and EPS. A degraded product mix can develop in three ways:
When a company's products are no longer in demand, PTP and EPS decreases often aren't far behind. An example is Eastman Kodak (EK). In the graph on this page, we can see that with increased use of digital cameras came a corresponding decrease in sale of film and traditional cameras (as shown with the red arrows). The result was a sharp decline in PTP and EPS.
Another unfavorable change is when a company's customer base shrinks. This is especially worrying when a company becomes overly dependent on one or two customers.
Since the downfall of Enron, people seem to be placing more emphasis on detecting fraud or accounting irregularities. While there's no foolproof way to determine all the possible accounting shenanigans, here are some red flags:
When a company's debt rating is lowered by the rating services, it usually has to pay a higher interest rate on loans. This is because the company is seen as having a higher risk of defaulting on its loans.
Finally, a company can be hurt by uncontrolled raw material costs. The airline industry, for example, has been particularly hard hit lately by the huge increase in its main raw material cost -- jet fuel.
The Stock Is Overvalued
Even the best-run companies can become overvalued. This often is because a company's stock price has gotten ahead of its fundamentals. You might want to consider selling a stock when it becomes substantially overvalued. The following four signs can help you determine whether a stock is potentially overvalued.
When a stock's price-earnings ratio is significantly higher than its five-year average, the P/E is likely to contract toward the historical average. Many seasoned BetterInvesting investors consider a stock to be overvalued when its relative value (RV), the current P/E divided by the average P/E, exceeds 150 percent.
Another indication that a stock may be overvalued is when the upside-downside (US/DS) ratio, a way of measuring risk and return, is less than 1-to-1. In the graph on this page, notice how the space above the current price is equal to the space below it. When the ratio dips this low, the risk of losing money is equal to or less than the chance that the stock will increase.
This shows an upside potential equal to our downside risk, or a ratio of 1-to-1. But what happens if the current price is $50? Suddenly the US/DS ratio would be 0.3-to-1. Our downside risk would be three times larger than our potential upside reward. Thus, the risk of continuing to hold the stock outweighs its reward.
The third indicator that a stock is overvalued is when its projected total rate of return is unacceptable. Though many BetterInvesting investors will only accept a predicted total annual return of 15 percent because this rate doubles their money every five years, this may not be the best approach. The potential rate of growth often indicates a stock's volatility -- the higher the number, the greater the risk. If you have only high-return stocks in your portfolio, you may be assuming too much risk. A better alternative may be to have a portfolio of stocks with a variety of returns, all averaging out to the desired 15 percent.
There are several ways to determine whether the potential return is acceptable. If the stock's projected compounded annual rate of return is equal to or less than that of a certificate of deposit or money market fund, the risk associated with holding the stock isn't adequately rewarded.
You'll also want to compare the compound annual rate of return with the desired rate of growth for the company's size. Does the projected return match the desired growth rate, as indicated by the table on this page? The idea is that small companies generally are riskier investments than large ones, so you want a higher growth rate for a small company to compensate for the increased risk.
This article has only scratched the surface of all there is to know about the art of selling. There's so much more to explore. The best way to learn is by doing.