Wall Street is littered with trading clichés: "Let your winners ride," "Bulls make money, pigs get slaughtered" and "A good exit is as important as a good entry." These notions highlight the real conundrum for investors. It's far easier to know when a stock is undervalued than when it's fully valued. In the past, investors didn’t need to know about when to sell -- they simply held onto a stock for a long time. My Grandma owned shares of the same Brooklyn utility for much of her adult life.
But conventional wisdom now implies that "Buy and Hold" is dead. That's because the stock market may no longer be a big gainer for the long haul. Instead, we may see a never-ending stream of rallies and sell-offs. To make money, you'll have to enter, exit and enter again when the time is right.
Here's a short list of telltale signs to look for that should tell you to head for the exit.
Throughout the 1990s and early 2000s, Dell (Nasdaq: DELL) generated steadily rising profit margins as the company continually streamlined its manufacturing processes and gained efficiencies as production volumes grew larger. You could have overlaid a stock chart onto a graph of the company's rising profit margins. The two moved in tandem. Yet as Dell's margins peaked, so did its stock. Shares of Dell touched $40 in 2005, and can now be had for around $12. Dell’s operating margin in 2005: 8.6%. 2009’s operating margin: 4.1%. It makes sense to ride a growth stock while its margins are expanding. But news that margins have flattened could be a cue to "exit right, stage left."
2. A sideways chart.
After an extended run, a company's stock may stop appreciating further, creating what is known as a "sideways chart." This is often a sign to sell a stock. That's because the sideways movement means that shares are no longer being solely supported by bullish buyers, but are now meeting resistance from an equally large group of profit-taking sellers. Eventually, when the buyers peter out, the sellers will rule the roost, and the next move in the stock is likely down. (The converse doesn't apply: A stabilizing stock after a steady fall doesn't mean it's time to buy. Those stocks can stay in a funk for several years, and it pays to let the stock chart show some life again before buying, even if that means missing early gains).
3. Competitor's warnings.
It's crucial to track the news coming from rivals in an industry. If your company is saying business conditions are good, while rivals say that things are turning south, your company probably just doesn't know it yet. In a similar vein, it's important to see how rivals are trading. If their share price is falling steadily, that could be a sign that industry conditions are deteriorating, even if nobody is talking about it just yet.
4. Portfolio size.
Portfolio theory holds that no single investment should comprise too much of your portfolio. I once worked for a portfolio manager that rode a stock up from $5 to $80. He looked like a hero to his clients. By then, that stock accounted for more than half of his portfolio. As the stock broke down, he couldn't to part with shares, and rode it all the way back to $20.
As a general rule, any time an investment rises in value to comprise more than 20% of your portfolio, you should sell at least some of that position to get that percentage back down. This is a bit controversial as fortunes have been made by resisting the urge to sell. If you bought Cisco Systems (Nasdaq: CSCO) at its IPO in 1991 and held on, then you'd have bagged an +80,000% gain 10 years later, even though Cisco would have been about 99% of your portfolio by then. (Then again, if you continued to hold Cisco through 2001, you'd have given back a lot of those gains).
5. Sharp rallies.
None of us have the ability to time the markets. Recent strength in the market could easily continue for an extended period. And slumps can be prolonged. But most of the time, sharp and fast rallies tend to fall victim to profit-taking and sharp market drops tend to bring out bottom-fishers. So unless you view a stock as a core long-term holding, it's best to zig when the market zags. If I'm holding a stock that has zoomed quickly from $15 to $21 and I think it's worth $23, I'll probably take profits anyway. There's a good chance that I'll be able to buy back in if a market pullback pushes shares back down into the teens.