Tough Sell : Knowing When to Unload Your Stocks Requires Diligent Monitoring

Many of the nation's top investors have one common credo: Buy good companies and hold them long-term. Billionaire investor Warren Buffett goes a step further. He suggests you buy good companies and hold them "forever."

But everyone makes an occasional mistake. Knowing when to cut and run can be as important as knowing what to buy.

Still, professional investors acknowledge that determining when to sell is tough, for reasons both psychological (it's hard to admit you've erred) and practical (you must keep a close eye on your portfolio).

"Knowing when to sell is probably the most difficult thing to do," says Ralph Bloch, technical analyst at Raymond James Financial Inc. in St. Petersburg, Fla. "Most people stay with the existing trend too long."

However, determining when--or if--you should sell is easier if you spend some time each quarter keeping up with your investments, and occasionally subjecting them to the detailed analysis that you conducted when determining which stocks to buy.

To do this with a minimum of time and effort, make a point of looking at the quarterly statements you receive. Publicly held companies send out statements every three months that show how their sales and earnings have fared over the period compared with the preceding three months and the year-ago quarter.

The statement also includes a message from the chief executive or chairman, which briefly describes the factors that contributed to that quarter's results.

Wise investors take a look at just a few key elements: profit, strategies and extraordinary items.

On the profit side, investors want to look at year-to-year comparisons of net earnings. Year-to-year earnings comparisons are usually better than quarter-to-quarter comparisons because many companies are subject to cyclical swings. A retailer, for example, is likely to post a higher profit in the final quarter of the year--Christmas season--than the following quarter. Consequently, to accurately gauge this company's growth, you must compare fourth-quarter with fourth-quarter, first-quarter with first.

When making the comparisons, ask: Are net earnings growing as fast as you expected when you purchased the stock? If they're not--no matter whether the earnings are much higher or much lower--you need to ask why.

For instance, has a one-time event, such as the sale of a profitable subsidiary, boosted near-term profit to the detriment of long-term results? Or has the company simply found more efficient ways to operate, which are likely to make it even richer over the long term? The answer to that question determines whether you should consider selling now--or buy more shares.

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If earnings have been disappointing, the analysis is the same. Are earnings down because the company is retooling to accommodate strong growth? Or because demand is slack or competition is stiff?

The answers to those questions are likely to be found in the chairman's message right at the beginning of the report. If the numbers you've reviewed--and that message--leave you with continued positive feelings about the company's prospects, you probably don't need to sell. Consider yourself a budding Buffett and keep a firm grip on your shares.

But shouldn't you check the stock price before you decide to hold? Even if the company's fundamentals are sound, doesn't it make sense to sell when the stock price has risen a set amount?

Probably not. If you sell to lock in a profit and the stock is not held in an individual retirement account or other tax-favored retirement plan, you've also locked in a taxable gain. In addition, you'll pay trading costs to sell and purchase new shares. Ultimately, your next investment must be substantially better than the first once you account for the tax and trading costs.

Consequently, many seasoned investors advise that you ignore the day-to-day price movements as long as you are convinced of the stock's fundamental value.

Only look at the stock price when the company's earnings are troubling and the chairman's message gives you further pause. At that point you use the current market price to calculate the firm's price-to-earnings ratio. You then evaluate its future prospects for growth by consulting the Value Line Investment Survey.

As we learned in last week's lesson on how to pick stocks, the P/E ratio can be calculated by simply dividing the current market price by the annualized earnings per share. If the resulting figure is less than the five-year projected earnings growth rate in Value Line, it may be best to hang on.

If, however, the P/E is higher than the projected growth rate, it's a signal that the stock price could decline. Naturally, you can hang on and hope for a recovery. But before you do, ask, "Is my money better invested elsewhere?" The corollary question: "Would I buy this stock today?"

It makes sense to hold on to a lackluster performer only if you think your prospects with other investments aren't any better. Holding on because you've suffered a loss and want to "get even" before selling only serves to put you farther behind, investment professionals say.

Consider Mary, who bought 100 shares of XYZ Co. at $10 each, but then saw the per-share price drop to $7, leaving her with a $300 loss. She decides to hang on, waiting for a recovery. Five years later, the share price does climb back to $10. But Mary shouldn't consider herself as breaking even.

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If she had sold five years earlier and reinvested $650 (the stock's $700 value minus a $50 trading fee--there is no tax when you have no profit) in another company that appreciated 10% annually--the market average--she would have had $1,069.45 instead of $1,000. Had Mary's initial investment been $100,000 instead of $1,000, that $69 she'd forgone would amount to $6,945. In other words, the more you have invested, the more it hurts to stick with a loser.

Says Bloch: "You buy a stock because you like it long-term, but then it slips 2 or 3 points. You say, 'Ah, no big deal.' Then it drops another 2 or 3 points and you say, 'I'll sell if I can get even.' Then it drops another 2 or 3 points, and I say, 'Now you are truly a long-term investor.' "

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