While I was traveling last week, I received an email that made me think long and hard about one of the more difficult tasks for an investor: selling. Because this reader's email asked about a couple of Bottom of the Barrel stocks, I figured it was time to think about the process of deciding when to sell your small-caps.
Compared with deciding when to buy, knowing when to sell is a chore. Hundreds of theories exist about when to sell, and all of them are right and wrong, depending on your investing philosophy and risk tolerance.
Ironically, selling discipline is
more difficult than buying discipline, largely because selling is always remembered. Just think about the sales you've second-guessed and compare them with the bad buys you remember. The sales stick out more vividly, at least more often than the reasons why you bought the stocks in the first place.
Most of my selling discipline is fundamentally driven. I've
written about what I look for when selecting a small-cap company. In a simplistic way, one reason to sell is if one of those tenets is violated. Here's a quick checklist of things to look for that
cause me to sell:
Change in management:
This is always a red flag for me. If I've owned a company that has a sudden management change, I usually exit without asking many questions. Confidence in management attracts me to a small-cap company. When that changes, it's hard to assess the future immediately. Therefore, unless the management succession is clearly articulated, orderly and expected, I almost always reduce my exposure. In the small-cap world, limiting uncertainty limits losses.
Change in business focus
: Many times, small-caps are like adolescents: They don't know what they want to be when they grow up. As those who follow my Bottom of the Barrel series know, I focus acutely on a company's business lines. So if there's a change in the business focus, even a subtle one, I take a hard look at the reason for it. That doesn't always induce me to sell, but it often signals that the current business plan isn't working. Again, I want to know what I own, and a surprising change usually compromises my position.
Change in capital structure
: This is more subjective but important. Clearly, a small-cap company that increases leverage is one to watch, as is one that may issue more equity. But this concept requires more analysis. More debt or equity could be for a very good reason in the small-cap world. For example, if it's to expand or to extend reach, product lines and the like, then the move might be a positive. But if a small-cap company raises capital -- debt or equity -- for a purpose that doesn't seem to fit the business model, take a closer look.
Change in performance
: This can also be more difficult than it seems. Although I'm usually quick to jump when performance comes in below my expectations, I do want to know why. There really are one-time events that can impact a quarter, but the company should have a darn good reason as to how it happened, why it happened and, most importantly, why it won't happen again. I have to trust the management team if I'm going to hang around after a bad quarter. If I decide to stay in the stock, I consider using a stop-loss order -- not so much because I have a price in mind, but more to hold me to my original discipline.
The list goes on and on, but those four factors are the beginning of a good fundamental checklist that can help you decide whether to hold or fold in the small-cap world.
The most difficult sell discipline to execute involves the price of any given stock.
Take, for example,
, the company that owns Longhorn Steakhouse, among other restaurants. The stock is up nearly 50% since I
profiled it in February 2002, generally for the reasons mentioned: good brand name, solid value, great management and some help from a slowly recovering economy.
With its recent success, a number of pundits have said the stock is expensive, and they downgraded it on the basis of valuation. I don't know whether that's important, but I do know that investors have decided that the stock is worth more because the company has performed on its promises. That's a good thing and, in my view, a reason I want to own the stock. After all, I want to own good companies.
That said, if the stock was trading at 14 times earnings expectations and is now trading at 18 times earnings expectations, it is relatively more expensive. As an investor looking for value, I want to find stocks cheap and watch them grow.
The good news is that I found Rare Hospitality when it was cheap, and it's been good. Now, the decision is when to cut it loose. That's where most investors face two tough challenges. First, never fall in love with your stocks. But, second, don't sell too early; let the winners run.
That's why selling on valuation is so difficult -- and why the decision is never completely satisfying.
Valuation sales are a very personal matter. They depend on your risk tolerance, the psychological reaction to cutting loose a winner and a whole spectrum of other emotions. Selling on valuation is an emotional decision, and emotions rarely facilitate good investment decisions.
That's why most investors are better off developing a formula and sticking to it. There are a number of ways to do that. One example is to say that after an "X% gain" in any stock, you'll sell half the position and put in a stop order "Y% below" the current market value. It really doesn't matter what the numbers are, as long as you're consistent. Only you know what number is right for you.
One other possibility is to take the forward price-to-earnings ratio of the companies in your portfolio and set an arbitrary "top valuation" level compared with that of its peers. For example, in this case, if Rare Hospitality trades outside an "X% premium" to the average forward P/E of its casual-restaurant peers, you'd sell.
These methods aren't foolproof, but they are consistent. Most important, they take some emotion out of a very emotional process.
Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to