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A Three-Step Checklist Before You Sell Stock

By Andrew Packer
Tuesday, 14 Jun 2011 08:21 AM Current | Bio | Archive

After six straight weeks of declines in the stock market, it’s tempting to throw in the towel. But that doesn’t mean you should.

While most investors focus on what to buy, they also need to remember that at some point, they’ll have to sell.

Investors who decide in advance the prices they’re willing to sell at tend to stay cash-heavy going into a correction, because they’ve already sold off near peak prices. Investors who don’t have a plan in place tend to find out that they’ve bought high — and then they compound their error by selling low.

Typically, there are three key reasons why an investor should sell:

First, there’s the general overvaluation of a specific investment. That means a position you own is now trading at a higher-than-expected price. If your original analysis of a company and its value hasn’t changed, then you should cash out.

Of course, overvaluation isn’t just a function of price. Rather, it’s what you can buy for that price. This isn’t a criticism of the underlying company, which may still be worth owning, just not at high prices.

There’s a big difference between buying Coke at 70 times earnings in the late 1990s versus buying shares at 17 times forward earnings today.

If an investment no longer has prospects to continue performing so well, chances are it will start correcting.

The second reason to sell is to take advantage of better opportunities.

Whatever the overall market does, there are always some companies that can buck the trend. If you continually rotate from what’s popular to the wallflowers of Wall Street, you’ll always be able to lock in profits on one investment and move on to the next opportunity.

It also means you’ve always got some money invested in the market, so there’s less emotion involved as to whether or not it’s time to “get back into stocks,” as I’ve noticed some investors sometimes do.

In recent blogs, I’ve highlighted some beaten-down tech companies like Cisco and Microsoft, as well as junior gold miners. They’re still great buys right here: The tech names have huge cash flow and rising dividends, and gold miners will see improved earnings from gold prices near their nominal highs.

Finally, the third reason to sell is that the company underlying the stock is showing signs of struggling. This isn’t any single thing, but here are a few examples: A company’s competitors may be knocking their socks off. Growth might be slowing. An important executive might be retiring or leaving for another job. The company’s cash hoard might be diminishing. The company may be talking about leaving its core competency and getting into some other line of business. The list goes on, but you get the idea.

In this category, if I owned Salesforce.com (CRM) I’d be a seller at today’s prices. The company’s financial metrics are weak (shares trade at over 300 times earnings!), earnings growth has been contracting, and the share price has risen almost fivefold since early 2009.

Investors should determine a sale price before they buy their first share of a position. That will help take some of the emotion out of the investment process, and avoid making the biggest mistake in investing: losing money.

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After six straight weeks of declines in the stock market, it s tempting to throw in the towel. But that doesn t mean you should. While most investors focus on what to buy, they also need to remember that at some point, they ll have to sell. Investors who decide in...

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