When should you sell a stock? That’s a key question that many investors find harder to figure out than buying the damn stock in the first place!
Then again, when you’re inundated with messages from brokers and banks urging you to buy, buy, buy a certain stock – knowing when to sell, sell, sell becomes something of an afterthought.
Unfortunately, it’s an afterthought that can cost you dearly if you don’t keep an eye on a stock’s performance and on a company’s actions.
Last week, we presented you with an article on how to pick great long-term stocks. This week, we’re presenting you with this article on 3 key situations when selling a stock might be your best option:
#1 A Company’s Key Advantage Becomes a Liability
A company, especially a well-established company can have many key advantages over its competition – it might have a better product, service, brand recognition, technology, talent or price than its competitors.
That being said, a company’s key advantages over its competitors may not last forever – case in point, Blackberry. The Canadian telecommunications company was once in the hands of every celebrity and was poised to dominate the U.S. smartphone market.
That was until the Apple iPhone “ate its lunch” with its trendy look and innovative touch screen whereas the Blackberry foolishly thought people would still dig its decision to stick with a QWERTY keypad. The rest as they say – is history. People loved the iPhone, people shunned the keypad, which was an integral part of Blackberry’s brand image.
If you purchased Blackberry stock on November 2003 at $44.35 a share, you would have seen your investment grow by about 80% to $148.13 on June 2008.
If you bought this stock and for some odd reason forgot about it just sitting around in your portfolio – you would be shocked to know that it has dropped to $9.40 as of August 2014, meaning that if you bought a lot (1,000 shares) on November 2003 at $44.35 a share ($44,350) – you would have lost 80% of your investment, that’s almost $35,000!
That’s why it pays to keep an eye on stock AND industry trends when evaluating your portfolio, because you never knew when you might need to dump a Blackberry-like stock.
#2 A Company’s Stock Has a Ridiculously High Price-to Earnings (P/E) Ratio
There’s a reason why many investors follow the maxim “buy low, sell high”. And ridiculously high Price-to-Earnings (P/E) ratios have a bit to do with it.
If you’re unfamiliar with what a company’s P/E ratio is, it’s simply a way of finding out whether a company’s stock is overvalued or undervalued.
Here’s an example:
If Stock A is currently trading at $50 a share and the earnings over the last 12 months were $1.35 per share, the P/E ratio would be: Price ($50) / Earnings ($1.35) = 37.03 (which is pretty damn high!)
Here’s what the P/E ratio tells you:
- A High P/E Ratio: Means other investors are willing to pay a greater amount for the stock’s earnings, which is a good sign the stock is overvalued.
- A Low P/E Ratio: Means a stock is more likely to be a better value since the market situation is probably responsible for the undervaluation.
When a stock is overvalued by some ridiculously high amount that generally means one thing – you can expect a mass selloff that’ll greatly reduce the stock’s value. And you don’t want to be holding onto that stock once it starts to tumble, so sell it once you recognise an insanely overvalued stock in your portfolio.
Note: While a high P/E ratio doesn’t always indicate that a stock is overvalued, you’ll want to compare the P/E ratio to that of other companies just to see if it’s grossly overvalued compared to its competitors.
#3 A Company Undergoes a Massive Change in Direction or Leadership
Keeping abreast of company news through its press releases and annual report is a good way to stay on top of its performance and future plans – both of which are important factors in determining whether to hold or sell a stock.
In fact, staying up to date with a company’s leadership and financial changes can is one of the most important thing you can do to determine whether a stock is worth holding onto or not.
Here are some warning signs to look out for when evaluating massive changes than can affect a stock’s performance just enough to get you to sell:
- The Company Changes its Leadership/Direction: You might purchase a stock because you believed in a company’s leadership (ex. Jeff Bezos at Amazon), products or business model. But if the company makes changes to any (or all) of those factors, it can definitely affect its profitability (and your decision to sell the stock).
- The Company’s Profit Margin Shrinks: If a company’s profit margin (profit after taxes, operating costs, etc. have been factored in) begins to shrink, it can mean the company’s expenses are starting to overtake its revenue. If the company’s profit begins to stagnate while its competitors are able to grow their profits, it’s probably time to dump the stock.
- The Company Cuts or Eliminates Dividend Payments: Dividends are one of the major reasons why you invest (passive income). However, when a company begins to slash or eliminate its dividend payments to investors, that usually means the company is either in expecting lower earnings OR is investing in research and development (R&D) or expansion. If it’s the former, consider selling. If it’s the latter, you might want to consider holding onto it.
The bottom line about company changes is that they will occur in EVERY company. But if you take time to evaluate what changes were made and more importantly, “why” they were made in the first place – you can make a more informed decision about whether or not to hold onto a stock or sell it.
Final Note: If you’re still new to the investing game (it’s ok, we all have to start somewhere right?), don’t forget to check out our article The 4 Biggest Investment Decisions Every Investor Should Never Forget. Also, check out our Investing Learning Center for some more great tips for investing beginners.