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| How to know a hot stock is cooling | |||||||||||||||
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When momentum slows, it's time adjust your portfolio. Any one of these indicators suggests your growth stock is fading -- and it's time to sell. By Harry Domash Many experts advise that avoiding disastrous losses is the secret to making money in the market. But, although everybody tells us how to pick stocks, advice on when to sell is hard to come by. So I came up with seven growth-stock selling rules that work for me. I focus on growth because value picks are usually busted growth stocks, and the disasters these rules are intended to avoid have already happened. Follow them religiously; otherwise you may end up counting yourself among the scores of accidental value investors.
Management says, Guess what? We wont meet forecasts. Strong, and even better, accelerating earnings growth is the fuel that propels growth stocks to lofty valuations. The best growth stocks routinely beat earnings forecasts. Analysts take note and increase their forecasts for the stock, propelling the share price higher. This dance can go on for years. Alas, growth eventually must slow. When the market realizes the acreage is overgrazed, investors dump the stock and move on to greener pastures. How can you get out before the stock dives? Fortunately, you have one of mankinds most reliable traits -- denial -- on your side. An important clue that the partys over is when management reduces guidance, meaning that the company wont meet earnings forecasts. Of course, company execs will try to reassure you that the shortfall is a singular event that will never, ever, be repeated. They draw on a variety of tried-and-true rationales to persuade you. For instance, theres the problems with a new production line rationale, or the ever-popular a big order got pushed into the next quarter ploy. Sometimes, creativity runs dry, forcing management to play the bad weather or earthquake in China card. When really desperate, they blame the slow economy. Many investors, including analysts, buy the story because they want the merrymaking to continue. Some players, however, see through the sham, so your stock will take a hit on announcement day. But thats nothing compared to the trouncing it will take when the company reduces guidance for the second or third time, and it finally sinks in that the salad days are gone forever. You can track guidance changes by watching the headlines for your stock, but its easy to miss the important stories amongst all the press releases and other less-relevant stories. Heres a solution: You can isolate guidance-change announcements using MSN Moneys slick Key Developments feature. Here's how to get there. After you get a quote for your stock, click on Key Developments on the left side of the page. When you see the dropdown menu, select Earnings Announcements to get just the news you need. Sell the first time that your company reduces sales or earnings forecasts. A competitor says, Guess what, Sometimes a competitor will reduce guidance before your company does, based on market conditions. Consider yourself the luckiest person in the world when that happens. Your stock will take a small hit, but youve basically dodged the bullet. Why? Your company is facing the same market conditions that tripped up the competitor, and will eventually reduce guidance, too. Its just that you lucked out and the competitor came clean first. Naturally, your companys management and its analysts arent going to tell you that. Instead, theyll say that the competitors problems were company specific, and dont apply to them. Dont believe it! Sell as soon as you one of your stocks competitors significantly reduces sales or earnings forecasts -- unless you have ironclad proof that the problems were indeed company-specific. The company makes a large acquisition Large acquisitions always sound as though they were made in heaven on announcement date. But an amazingly high percentage end in disaster. Think AOL and Time Warner, Daimler Benz and Chrysler, WorldCom and MCI -- the list goes on and on. The reasons vary. Sometimes the acquired companys reported sales and earnings were imaginary numbers. Sometimes theres a culture clash and key employees of the acquired company leave. Sometimes a company buys another simply to mask its own slowing growth. Well leave those explanations to the academics, because, in the end, it doesnt matter. All you have to know is that your chances of making money seriously diminish when your company makes a big acquisition. Sell when your company announces any acquisition that will increase its annual sales by 25% or more. The company restates financials Restatements mean that a company is correcting financial reports that it had already filed with the SEC. Thats not a problem if the mistake was benign -- for example, if the company misapplied some arcane accounting rule or understated earnings. Unfortunately, many accounting restatements stem from overstating sales or understating costs to hype reported earnings. The news that a company is restating earnings downward usually sinks the stock price. But thats the good news! The bad news is that the first restatement is unlikely to be the last. Probably new auditors will come in and find more reasons to readjust historical earnings downward. In some cases, the revelations will cast doubt on the companys ability to survive. You can use the Key Developments feature described above to see earnings-restatement announcements. Select All Developments on the dropdown menu. There is nothing to gain from waiting for more shoes to drop. Sell the first time your company announces a significant downward earnings restatement. Same-store sales head south Restaurants and retail-store chains gain can grow sales by opening new locations or by increasing sales at existing locations. The latter contributes more to profits because the company doesnt have to spend money on equipping new buildings, hiring staff, etc. Thats why savvy investors consider same-store sales growth, the growth attributable to locations open at least a year, to be the best measure of a company's long-term growth prospects. Negative same-store sales growth means that sales at existing locations are declining, a harbinger of slowing earnings growth, negative surprises and other bad things. Restaurant and retail chains report same-store sales growth at least quarterly, and often monthly. You might ignore a single month, but sell any restaurant or retail store reporting negative same-store sales growth during its most-recent quarter. Operating margins go on the decline Tracking year-over-year trends in operating margins is a great way to get a read on how your company is doing in its market. Operating margins measure profitability, considering everything except interest expenses and income taxes. Declining operating margins usually signal that something is going wrong. Why? Operating margins drop because: A) The company is cutting prices to retain market share against aggressive competitors, and/or B) costs are increasing faster than sales. Neither is a good thing. Deteriorating operating margins usually signal declining market share, reduced profits or both. A step-up in research-and-development spending to accelerate new product introductions would be the only mitigating circumstance. Analyze operating-margin trends by comparing the most-recent quarters margin to the year-ago figure. Looking at year-over-year numbers eliminates seasonality effects. Youll need a calculator to analyze the margin trend, but its easy to do using MSN Moneys quarterly income statements. Find it by getting a stock quote and then selecting Financial Results on the left side of the page. Next, click on Statements (listed below Financial Results) and select Quarterly from the dropdown menu labeled View. The operating margin is simply the operating income divided by sales. EBIT (earnings before interest and taxes) is another name for operating income. Let's calculate operating margin using the income statement for Wal-Mart Stores Small operating-margin variations are normal, and not a cause for concern. Only changes amounting to 15% or more (e.g., 17% down from 20%, or 42% down from 50%) are significant. Sell any stock with a 15% or greater year-over-year drop in operating margins unless you find mitigating circumstances such as a major new development activity. The price chart takes a dive Astute growth investors pay close attention to price charts. In fact, many only consider up-trending stocks as viable growth candidates. A faltering uptrend is often your first signal that in-the-know players are dumping shares before bad news hits. How do you know when an uptrend is turning into a downtrend? Chart interpretation is a subjective art, and experts often disagree. Comparing a stocks current price to its 50- and 200-day moving averages, although not ideal, is an objective method of determining a stocks direction. Most experts would agree that a stock trading below both its 50- and 200-day moving averages is in a downtrend. You can find the current price and the value of both moving averages by getting a price quote and then selecting Company Report in the left column. Sell any stock trading below both its 50- and 200-day moving averages. Ive listed seven selling rules, but its not a four-out-of-seven game. Each event tilts the risk/reward balance against you. My approach is to sell when any one event happens. At the time of publication, Harry Domash did not own or control shares of any equities mentioned in this column. | |||||||||||||||
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