You can find plenty of tips about stocks to buy, but nobody tells you
when to sell.
Here are three “red flags” signaling that it’s time to bail out. They
apply primarily to growth stocks, which are companies that are expected
to achieve strong sales and earnings growth. These are the stocks that
interest most investors because, all else equal, fast growth usually
translates to big share price gains.
Most investors expect that firms that already racked up strong numbers
will continue to grow at the same pace, or even faster.
Alas, that can’t happen. Sooner or later, growth slows. That usually
happens when a firm begins to saturate the market, or its success
attracts competitors that want to get in on the action. Whatever the
reason, news of slowing growth almost always kills the share price. Your
gains will evaporate, or even turn into losses if you wait until the
word is out before you sell.
Here are the three “red flags.”
The operating margin is the profit a company makes by selling its
products before paying income taxes. For example, a 25% margin means
that the firm makes $25 for every $100 of sales.
The operating margin tells you a lot about a firm’s competitive
position. For starters, companies with less desirable products must
charge less than firms that dominate their markets. Also, some firms are
able to produce products at lower cost than competitors. For one or both
reasons, the best players in any industry record higher operating
margins than the also-rans.
Although margins vary by industry, and within an industry by time of
year, you can see whether a company’s market position is improving by
comparing its recent operating margin to historical values. Rising
margins reflect an improving competitive position and vice versa.
You can use Quote.com (www.quote.com)
to see quarterly operating margins for most firms. Get a quote and then
quarterly income statement (Financials menu) to see operating
margins going back five quarters.
Compare the most recent operating margin to the year-ago quarter. Small
variations (e.g. 24% vs. 25%) are normal. Consider a 20% (e.g. from 25%
to 20%) or greater drop as significant, and thus, a sell signal.
Changes in analysts’ earnings forecasts often predict the future.
For instance, say that two months ago, analysts were expecting a company
to earn $1.00 per share in 2010, but now they are only expecting it to
report $0.85 for the year. That negative trend tells you that analysts
have detected a deteriorating fundamental outlook for the company.
Usually, when that happens, the firm’s outlook continues to weaken, and
its actual results will be even worse than expected.
You can see the earnings forecast trend on MSN Money (moneycentral.msn.com)
Consensus EPS Trend section of the Earnings Estimates report.
MSN displays forecasts for the current and next quarter, and for the
current and next fiscal year. Pay most attention to the current fiscal
year’s forecasts. Consider any significant decline (3 cents or more)
within the past two months as a sell signal.
Declining Price Chart
Many times, a falling stock price triggered by clued-in holders selling
in advance of bad news is your first clue that something is going wrong.
Thus, it’s important to keep a close eye on your stocks’ price action.
Although no stock goes up every day, growth stocks should be in
uptrends, meaning that they are generally moving up in price. By
contrast, a downtrend means that the stock is mostly heading down.
You can compare a stock’s current price to its moving average (average
closing price over a specified number of days) to determine which way
it’s trending. It’s in an uptrend when trading above its moving average
and in a downtrend when trading below. The 50-day moving average
typically defines short-term action while the 200-day moving average
works for assessing longer-term trends.
You can use Yahoo’s Key Statistics report (get a
Statistics) to see the current price and both the 50- and 200-day
Ideally, growth stocks should be trading above both moving averages,
signaling a strong uptrend. A stock trading below one moving average
bears watching closely. It’s a “sell” signal when trading below both
moving averages unless it is reacting to bad news that is of short-term
All three of these ‘red flags’ are equally significant. Sell when you
detect any one of them. Your stock will probably already be off its
high, and you’ll be tempted to wait to see if it recovers. Don’t!
Bad news usually leads to more bad news.