If you are ready to sell a stock, first answer 4 questions

Assess the reasons for purchase, value, place in portfolio, fundamentals

Dollars & Sense

April 21, 2002|By Pat Dorsey | Pat Dorsey,MORNINGSTAR.COM

Last week, I talked about all the reasons you don't want to sell a stock. Now, let's look at the times when breaking up really is the right thing to do. Whenever you think about selling a stock, run through these four questions.

Did you make a mistake?

In other words, did you miss something when you first evaluated the company? Perhaps you thought management would be able to pull off a turnaround, but the task turned out to be bigger than you thought. Or maybe you underestimated the strength of a company's competition, or overestimated its ability to find new growth opportunities.

No matter what the flub, it's rarely worth holding on to a stock that you bought for a reason that's no longer valid. If your initial analysis was wrong, cut your losses and move on.

I did this a while back with a manufacturer of commercial movie projectors. My growth expectations turned out to be way too high, since the multiplex-building boom of the 1990s was waning. Theater owners started to get into financial trouble, and they were a lot more worried about paying their bills than building theaters. I was down quite a bit on the investment by the time I figured this out, but I sold anyway. Good thing, too, since the shares plunged to penny-stock territory.

Have the fundamentals deteriorated?

After several years of success, that raging growth company you bought has started to slow down. Cash is piling up as the company has a tougher time finding profitable investment opportunities, and competition is eating away at the company's margins. Sounds like it's time to reassess the company's prospects. If they're substantially more grim than they used to be, it could be time to sell.

Has the stock surpassed its intrinsic value?

Let's face it: Mr. Market is a capricious individual, and sometimes he wakes up in an awfully generous mood and offers to pay you a price far in excess of what your investment is really worth. There's no reason not to take advantage of his good mood. What you need to ask yourself is how likely it is that your estimate of the worth of the company could go up over time. If your estimate of intrinsic value is likely to rise, then it's worth waiting out periods of mild overvaluation.

Generally, it doesn't take much in the way of a valuation premium to persuade me to sell stocks with minimal economic moats - when they get close to their fair values, I'm out. However, I won't sell stocks with wide moats - ones with fair values that are likely to rise over time - on valuation concerns unless they're egregiously pricey, in which case I'll happily take Mr. Market's generous offer and move on.

Has the stock become too large a part of your portfolio?

Any time one stock grows to become more than 10 percent of your portfolio, you should start thinking carefully about how much risk you're taking on. Even if you still think a company has great prospects, it's simply not prudent to allow it to take up too large a percentage of your portfolio. I learned this lesson the hard way a few years ago. I'd bought a few hundred shares of a small company called EMC in 1995, and five years later it made up more than a third of my portfolio. I sold some shares, but not nearly enough. As a result, I suffered more than my fair share of the tech downdraft.

Of course, spreading your risks around applies to larger categories - like sectors, market caps and styles - in addition to individual stocks. Any time you find that too much of your portfolio is in one area of the market, then you've probably got yourself some good sell candidates. Morningstar's Portfolio X-Ray and Stock Intersection are great tools for this.

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