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.

Related Articles
  1. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  2. Investing

    What is EBITA?

    EBITA measures a company’s full profitability before reducing it by interest, taxes and amortization considerations, and so is useful for calculating a company’s internal efficiency or profitability ...
  3. Term

    What Is Financial Performance?

    Financial performance measures a firm’s ability to generate profits through the use of its assets.
  4. Investing

    How to Effectively Monitor Your Stock Holdings

    Investors should concentrate on the business, not the stock price.
  5. Economics

    Understanding Explicit Costs

    Common examples of explicit costs include wages, utilities, rent, raw materials, and other direct expenses companies pay to conduct business.
  6. Stock Analysis

    These S&P 500 Companies Hold the Most Cash

    Large cash positions allow for many different options and here's why they are beneficial to shareholders.
  7. Investing Basics

    What Does Off-Balance Sheet Mean?

    Assets or debts that a company excludes from its balance sheet are off-balance sheet items.
  8. Investing Basics

    Explaining Noncurrent Liabilities

    Noncurrent liabilities are financial obligations a company owes a year or more into the future.
  9. Investing Basics

    Calculating Net Cash

    A company’s net cash is its total cash remaining after it subtracts all liabilities.
  10. Fundamental Analysis

    The Thrilla in Manila: Yahoo Finance Versus Market Watch

    An unbiased comparison of the two major financial tools.
  1. Does working capital include inventory?

    A company's working capital includes inventory, and increases in inventory make working capital increase. Working capital ... Read Full Answer >>
  2. Does working capital include salaries?

    A company accrues unpaid salaries on its balance sheet as part of accounts payable, which is a current liability account, ... Read Full Answer >>
  3. Are dividends considered an asset?

    Whether dividends paid on stock are considered an asset depends on which role you play in the investment: the issuing company ... Read Full Answer >>
  4. What is a profit and loss (P&L) statement and why do companies publish them?

    A profit and loss (P&L) statement, or balance sheet, is essentially a snapshot of a company's financial activity for ... Read Full Answer >>
  5. How do dividends affect the balance sheet?

    Dividends paid in cash affect a company's balance sheet by decreasing the company's cash account on the asset side and decreasing ... Read Full Answer >>
  6. Who actually declares a dividend?

    It is a company's board of directors who actually declares a dividend. The declaration date is the first of four important ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!