Read This Before You Sell

By Glenn Curtis AAA

Wall Street analysts and brokers do a terrific job of telling investors which stocks to buy and why, but these same experts have failed miserably when it comes time to sell. As a result, the average investor is usually left to fend for himself when determining when it is most appropriate to sell their investments.

The good news is that there is an easy way for you to decide for yourself. In this article, we'll give you a list of five telltale signs that you can use to determine whether it's time to bail out of an investment.

1. Loss of a Key Employee
Every company suffers some degree of attrition, but when a key employee such as the chief executive officer (CEO), chief financial officer (CFO) or head of research quits, especially with little or no notice, it is often a sign that the company is headed down the wrong path.

Think about it. If things were so good, why would these front-line executives (who are typically well compensated for their efforts) be so eager to jump ship - especially without ample notice? There are valid reasons why a top manager might quit, including to garner a higher salary or to take on more responsibility. But as a matter of course, investors should view high-level departures as a red flag.

Example - Novell
In 2001, Novell (Nasdaq: NOVL), a well-known software maker, was in the midst of a major turnaround when its chief executive officer, Eric Schmidt, abruptly quit. After Schmidt left the company to join Google (Nasdaq: GOOG), Novell lacked direction, and its sales waned. In fact, the firm wandered aimlessly for about a year until new management finally righted the ship through corporate restructuring and product refinement. However, making matters worse, Schmidt unloaded a portion of his stock position in the open market. The outcome was that Novell\'s share price dropped from roughly $4.75 to below $2 in the following year. In this case, investors could have saved themselves a great deal of money had they sold off their stock once they heard this top officer had jumped ship.

2. Consistently Missing Estimates
Every company goes through tough times. So, when a firm misses earnings estimates in any one quarter, it isn't necessarily something to worry about. But when a company misses earnings estimates in two consecutive or related quarters, investors should consider selling the stock and heading for greener pastures. After a second consecutive earnings shortfall, the market tends to lose confidence in the company's management and the shares suffer. (For more insight, read Strategies For Quarterly Earnings Season.)

Example - Cyberonics
An example of how this "two strikes and you\'re out" rule works can be found in an analysis of medical device company Cyberonics (Nasdaq: CYBX). In October 2005, it missed earnings estimates by a long shot. Management explained the shortfall, and the investment community took the first miss in stride. As a result, the stock barely budged in value.
But when the company missed earnings estimates in the following quarter, the market wasn\'t as kind. Retail and institutional investors bailed en masse and shares declined in value by 40% in the following six months. If an investor had sold his Cyberonics shares immediately after the second earnings shortfall, the losses wouldn\'t have been nearly as bad. Exiting a position as it is dropping is better than exiting when it has hit rock bottom.

3. Inventories Are On The Rise
When a company is growing its sales at a fast 10% clip, logic dictates that its merchandise inventories should be growing at about the same pace. However, if a company's inventories are rising at a faster rate than its sales, this may indicate that the company is having trouble selling its merchandise.

The problem is that management only has a few remedies for such a situation, and none of them are good:

  1. Option No.1: It could store the merchandise until a later date in the hope of selling it, but this costs a great deal of money in terms of holding costs.
  2. Option No. 2: It could mark down the merchandise and that consumers will buy the product, but this method will definitely hurt profit. Remember, the retailer has the same cost basis for the goods regardless of the price at which it is able to sell them.
  3. Option No.3: It could write off the inventory entirely, and chalk up the merchandise lot as a total loss.

Each of the above scenarios will have an adverse impact on earnings and, by extension, the company's share price.

The good news for investors is that a company's inventory levels are easy to check. Simply review the company's last balance sheet (which may be obtained through the SEC's website). Under the heading "assets", you'll find an inventory number. Investors should compare that number to last year's number, which is typically in the column right next to it. Is the inventory number growing at a markedly faster rate than sales? If it is, and the company isn't gearing up for its big selling season, it may mean trouble. (For more information on balance sheets, check out Breaking Down The Balance Sheet, Reading The Balance Sheet and What You Need To Know About Financial Statements.)

Example - Ann Taylor
Rising inventories can hurt a company, as evident in Ann Taylor\'s (NYSE: ANN) 2005 10-K. In that filing, the women\'s apparel retailer reported that its inventories swelled 33% from $172 million (in January 2004) to $229 million (in January 2005). With total sales growing at just 17%, it was fairly obvious that the company was in trouble.
In the end, Ann Taylor wrote off a host of obsolete inventory. But by the time the company purged the excess merchandise from its books, the stock price had been pummeled.

Remember, be wary of rising inventories, and at the first sign of trouble, sell.

4. Receivables Are Increasing
A company's ballooning accounts receivable balance (again, found on the balance sheet) can indicate that it is having trouble getting paid for its products or services. Again, like the inventory, accounts receivable should grow at approximately the same pace as sales. If, however, that number is growing at a considerably faster clip, it may indicate that a revenue and/or cash flow shortfall may be just around the corner.

Example - Lucent
An example of stale receivables and their effect on a company can be found in an historical analysis of Lucent (OTC: LUTHP). In 1999, the technology company experienced dramatic increases in its receivable accounts, which were growing at 41% while sales grew only at 20%). It then experienced significant problems generating free cash flow, primarily because it wasn\'t able to convert those receivables into cash. Not coincidentally, the company experienced a major decline in its share price in the following year.

5. A Lack of Sales Growth on the Horizon
Stock prices generally reflect investors' expectations about what will happen in the future. Therefore, if a company does not expect meaningful revenue growth in the foreseeable future, the stock price will most likely wane.

Example - Merck

The popular drug maker, Merck (NYSE: MRK), experienced a situation like this in 2000. Merck\'s CEO, Raymond Gilmartin, indicated that the company wouldn\'t take part in the acquisition frenzy that was sweeping the drug industry. Instead, he suggested that the company\'s own research team would develop the drugs it needed in house to increase revenue and profits - even if it would take several years to fill its drug pipeline. By doing this, Gilmartin gave investors the impression the company wasn\'t moving forward, and was stagnating. Merck\'s stock declined in value by about 50% over the next seven years. Again, all of this was due to a lack of visible growth opportunities.

Unless there is a catalyst on the horizon, or some tangible proof that the company will improve its revenue and earnings within a reasonable time frame, consider selling the offending company's shares to protect yourself from future losses.

Bottom Line
Knowing when to buy a stock is important, but knowing when to sell that stock is equally important. Investors should be aware of the telltale signs including: losing important employees, missing growth estimates, rising inventories, increasing receivables and a lackluster sales growth projections. If you watch out for these five "buyer beware" signs, you should be able to quickly decide when to sell your stocks, before they take a massive nose dive.

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