7 Red Flags That Say It's Time to Sell

By David Sterman Thursday, November 18, 2010

Few investors have an unlimited supply of money to keep buying new stocks. So to maintain a healthy dose of cash for the next stock purchase, most investors need to keep an eye out for opportunities to sell existing holdings (hopefully with a nice gain).

In some instances, you'll have a clear sense of what a stock is worth, and can simply sell your investment when shares have risen to your target price. But in most instances, no clear-cut exit exists. When that's the case, keep holding your shares as long as business is going well. Just keep monitoring these seven red flags that may signal it's time to sell.

1. Watch the insiders. From time to time, an officer or a director at a company may look to sell shares -- especially if the stock has steadily risen in recent weeks. That's perfectly understandable. But when several of them do so at the same time, you should probably follow their lead. On November 9, three separate insiders at Dreamworks Animation (Nasdaq: DWA) sold a collective 114,000 shares netting them a cool $5 million. If they don't think the stock holds value anymore, why should you?

[History shows that stocks heavily purchased by corporate insiders outperform the broader market averages by roughly 2-to-1. To learn more about this and other market timing techniques, read How to Excel at Timing the Market.]

2. The analyst disconnect. One of the most common mistakes an investor can make is holding onto a stock that seems fishy, but is still liked by analysts. As you listen to a company's quarterly conference call, you may get a sense that business is tumbling, and management is trying to put a positive spin on things. Analysts often buy into that positive spin, and will stick with their Buy ratings as a result. Go with your gut. If you think something is amiss, you are probably right.

3. Industry pressures. It's also important to hear what the competition is saying. If the management of the company in which you are invested says industry conditions are just fine, but a key rival says that business is getting tough, stick with the cautious view. Increasingly difficult conditions at a rival may simply signal company-specific execution problems, but that beleaguered rival may need to take desperate steps such as a price war to maintain sales levels. And in a price war, nobody wins.

4. SEC investigation. You'd be surprised how many investors hang on to a stock after hearing that a company is being investigated by the Securities and Exchange Commission. They're being foolish. In most instances, there is a real problem at hand even as companies typically look to downplay any investigation as seemingly minor. Even in a best case scenario where there is no wrongdoing, investigations can drag on for months, causing a stock to stay out of favor. This is a clear case where it's best to "shoot first and ask questions later."

5. Decelerating sales growth. As a young company grows larger and larger, it's inevitable that sales growth will need to slow down. It's a lot easier to boost sales +40% when you only have $25 million in sales than it is when you have $1 billion in sales. But such a slowdown should be measured and orderly. When sales growth slows sharply, or even turns negative, it could be a sign that a company has hit a serious wall. Management will likely explain any slowdown as a mere hiccup, but you'll need to dig deep to find out the root cause.

6. Shrinking profit margins. The first rule of business is that as sales grow, a company can generate leverage off of its fixed expenses. And that means that profit margins (gross, operating and net) should always be expanding. But if profit margins shrink, even as sales turn higher, then it's a clear sign that a company is losing pricing power. And once profit margins start to slip, they often keep falling as rivals fight harder and harder to steal market share.

7. An abrupt management change. We recently discussed this notion, highlighting the risks that arise when a top member of the management team suddenly departs.

It's not always a cause for alarm, (for example when someone is simply retiring), but you'll want to hear a good explanation of the change, and hopefully about a successor that has already been lined up.

As a good rule of thumb, once you own a stock, you should be looking for reasons to sell. If no such reasons emerge, then you can sit tight on that investment for an extended period. But if any of these seven red flags arise, it may be a clear sign to get while the getting is good.

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