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When to Sell: Discipline Over Emotion

David Edwards

Deciding to sell a stock is much tougher than deciding to buy one.

If you're selling at a loss, you may be psychologically opposed to "realizing the loss," because it means you made an error in your analysis. If you're selling at a gain, you may be unhappy about the taxes you'll owe, and you'll be second-guessing yourself about whether you left money on the table.

Successful investors, therefore, have to develop a discipline about when to sell a stock. Here are rules we apply to our client's portfolios.

Rebalancing

In a diversified portfolio, consider selling half of any position that exceeds 10% of the portfolio. Typically, we initiate a position at 2% to 3% of assets. If a stock doubles, triples or quadruples in a short time frame, the position can grow to a large percentage of the portfolio. If we had kept every share of Dell Computer (DELL Quote - Cramer on DELL - Stock Picks) we ever bought starting eight years ago, we would have had about 35% of our clients' assets in that company by January of this year. This is fine on the upside, but horrible when a big position takes a big tumble.

No matter how good a company is, the stock eventually will have a substantial pullback. Disagree? Take a look at the Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) chart.

By automatically cutting back on positions with big runs, we pay some taxes on the realized gains, but we avoid the risk of a substantial hit.

The same discipline applies to sector concentration. By the end of 1999, 40% of our positions were in technology, reflecting the huge rally in technology stocks last fall but exceeding our target of 25% for that sector. We shifted 15% of these assets to financial services, a sector that performed so poorly in 1999 that our exposure had fallen to 11% from our target of 25%. This shift did nothing for us January through March, but totally paid off for us in April and May.

Consecutive Earnings Misses

When a company fails to meet earnings estimates two quarters in a row, it's because management doesn't have a good handle on the company's prospects and has given poor guidance to the analyst community. In our minds, Xerox (XRX Quote - Cramer on XRX - Stock Picks), Lucent (LU Quote - Cramer on LU - Stock Picks) and Motorola (MOT Quote - Cramer on MOT - Stock Picks) are candidates for sale following recent misses.

Earnings Restatements

Any company that has to restate its earnings is an automatic sell at our firm. An earnings restatement says the company's management has no idea what the company's true financial condition is. It's like flying a plane in the dark with malfunctioning instruments. Sunbeam (SOC Quote - Cramer on SOC - Stock Picks) restated its earnings three years ago. How's this for an ugly chart?

We keep a folder of companies that have restated in the past 10 years. The only substantial company to ever make a comeback from that was Oracle (ORCL Quote - Cramer on ORCL - Stock Picks), which restated its revenue accrual methods in 1990. Even then, it took three years for the company to make a new high.

Technical Breakdowns

If you're a chartist or use technical indicators in your research, consider cutting back any company with a ballistic curve chart, i.e. a company whose stock price has gone higher at an increasing rate of change. This chart indicates that either a buyer's panic is driving the surge or that short-sellers are getting squeezed. Once this fuel cuts off, the stock tends to drop sharply. Quest Diagnostics (DGX Quote - Cramer on DGX - Stock Picks) has had a terrific year in terms of corporate growth, but last week's solid earnings report failed to attract new investors and the stock sank 29% in three days.

The same analysis could have been applied to the Nasdaq through March of this year.

Notice that in both charts, double tops (failure to break through a previous high) warned of trouble to come.

One technical indicator that seems to have lost its utility is a breakdown through the 200-day moving average. By the time a stock triggers this indicator, you've lost so much money that exiting the position hardly matters.

Fundamental Changes

Any company whose niche product becomes commoditized is a candidate for sale. There was a time when 3Com (COMS Quote - Cramer on COMS - Stock Picks) owned the market for network adapters and US Robotics owned the market for 33.3 kilobit modems. The two companies peaked in market value as a merger four years ago, just as Intel (INTC Quote - Cramer on INTC - Stock Picks) and Rockwell International (ROK Quote - Cramer on ROK - Stock Picks) entered those segments with adapters and modems that were better, faster and cheaper.

It took the introduction of the Palm Pilot (a revolutionary product that accounts for a small percentage of 3Com's total sales) to reignite interest in 3Com's stock. This interest is now dissipating with the spinoff of Palm (PALM Quote - Cramer on PALM - Stock Picks) as a separate business.

Particularly dangerous to companies is the paradigm shift. Once upon a time, IBM (IBM Quote - Cramer on IBM - Stock Picks) ruled supreme over corporate computing through powerful, expensive mainframes. A tiny division of the company in Boca Raton, Fla., spawned a device (the personal computer) that allowed other companies (Intel, Microsoft, Compaq (CPQ Quote - Cramer on CPQ - Stock Picks)) to subvert IBM's sales. IBM's stock price peaked in 1987, and it did not make a new high until 1997, when the company had evolved into a consulting and services provider.

So when you see the introduction of a new paradigm, cut back or sell off your positions that depend on the older paradigm. You could have protected your profits in Compaq, for example, when its manufacturer/distributor/customer sales model was overtaken by Dell's customer direct model, or when Microsoft's desk-centric computing model was overtaken by the Internet's distributed computing model.

When Not to Sell

If you like your companies and are confident in your research, the worst time to sell is during a correction. An investor called me last May and announced he had sold his entire portfolio at a 40% loss on the year. The portfolio contained many risky emerging technology companies, but also some solid blue-chips such as General Electric (GE Quote - Cramer on GE - Stock Picks), Fannie Mae (FNM Quote - Cramer on FNM - Stock Picks) and Cisco (CSCO Quote - Cramer on CSCO - Stock Picks). Sure enough, he nailed that lowest point of the lowest day for the entire year.

If you like margin trading, never use more than half the leverage that's available to you. There's nothing worse than being taken out by a margin call only to see your stocks rally the next day.

If the analyst community downgrades a stock, it's practically a buy signal. Analysts generally are earnest, hard-working people who know their industries inside and out. But the politics of the sell-side firms make timely buy and sell recommendation almost impossible. For example, there was a slew of analyst downgrades of Intel in late September, when you would have been lucky to get out at $45 a share. The same analysts generally had buy ratings when the stock had been at $75 a month earlier. One month later, the stock is heading back above $45, so what's the utility of the downgrades?

Don't sell when a stock hits a price target. A company's stock price moves all over the place, depending on market, sector and company-specific conditions. The more useful analysis is whether a stock has good reasons to continue outperforming alternative investments.