Investing Wisely

Decide what to sell

Follow these guidelines, and you'll know which stocks to hold—and which to fold.

By Dennis Murray
Senior Editor

Sometimes, knowing whether to hold or sell a stock or mutual fund is a great deal harder than knowing when to buy it. Just ask the folks whose investments got caught on the tracks during last year's "tech wreck." They learned painful lessons about inflated stock values and the importance of diversification.

Even if you're a conservative investor who has avoided big losses, you can't ignore sell signs. If you own stocks and funds that haven't earned much in years, they may be candidates for a fire sale.

How can you determine whether your investments—even those that have done well—still belong in your portfolio, or whether their best days are behind them?

Individual stocks: Stay vigilant, or stay away

For each stock you own, start by asking yourself whether you're still comfortable with the way the company sells its products or is expanding its business. "If all of a sudden you find the company doing something contrary to what the president's letter to shareholders said in the annual report, that's generally an indication to sell," says Fred Lynn, a money manager and president of F.A.L. Capital Management in Scottsdale, AZ.

Even a company that sticks with its business plan may be a candidate for selling. "A lot of people lost money on telecom and Internet stocks because they failed to do their homework," says James F. Ferrare, a money manager with Pinnacle Associates in New York City. "They got caught up in the buying hysteria and didn't take the time to examine the amount of debt a company had or whether it was generating earnings."

Excellent sources for this and other key information about companies include Barron's, The Value Line Investment Survey, and The Wall Street Journal, which most libraries carry. Or on the Web, visit Morningstar.com ( www.morningstar.com ), Quicken.com (www.quicken.com ), and Yahoo! Finance ( finance.yahoo.com ). These sites monitor insider trading as well, which can also signal when it's time to abandon ship. If you notice unusually active selling for reasons that aren't explained or seem questionable, beware. "I heard an executive justify selling a huge number of his shares in the company by saying that his son had been accepted to Columbia University," Lynn recalls. "Since when did Columbia's tuition cost $10 million?"

Another indicator you'll want to examine is earnings estimates. A company that misses its estimates over two or three consecutive quarters may be in trouble. "Every company is entitled to a bad quarter or two," Lynn says, "but a pattern is cause for concern."

Dwindling return on equity could also be a sell sign. Morningstar defines return on equity as a measure of how well the company has turned each dollar of shareholders' equity into earnings. It's calculated by dividing the company's net worth into its net income.

"Generally, there's a high correlation between ROE and the stock's future performance," Lynn says. "The current ROE might be high, but if it has been declining, the stock price will probably come down with it." On the flip side, a rise in ROE of 16 percent or more a year is a strong sign to hold—and perhaps to buy more shares.

When deciding whether to unload a stock, you should also visit the company's Web site. You'll probably find an investor-relations section where you can review annual and quarterly reports (Forms 10-K and 10-Q), company news and press releases, and messages from the chairman. The Securities and Exchange Commission posts 10-Ks and 10-Qs for publicly traded companies (except foreign companies and those with less than $10 million in assets) at www.sec.gov/edgar.shtml .

You'll make savvier keep-or-ditch decisions if, as many advisers suggest, you set price targets and reanalyze each stock after it reaches the target, or after a specified time period—whichever comes first.

"If the stock hits the target within the time frame, you should sell in most cases," says Lawrence Howes of the Denver financial planning firm Sharkey, Howes & Javer. "But if you're a long-term investor and the fundamentals are good, you can hold it and set a new price target." He recommends that you re-examine a domestic large-cap stock after it rises 10 percent, and a domestic small-cap after a 15 percent increase. Furthermore, if any stock you own loses 10 percent or more, you should consider dumping it.

Admittedly, it takes time and discipline to set targets and track your stocks. But the process will keep you from hanging on to duds for years, a common investor mistake. "Some people refuse to sell their stocks because they can't stand the thought of taking a loss," says Ferrare. "But if the company's outlook is poor, it makes no sense to hang on. Sell the stock and use the loss to offset another holdings taxable gains."

Funds: Review them at least annually

Because funds are run by professional money managers who spread your risk over dozens or hundreds of companies, you don't have to monitor them as closely as individual stocks. But you shouldn't ignore your funds, either. Review them at least once a year to see whether they're worth keeping.

First, check each fund's current investment strategy, to see whether it has remained true to its charter. For example, let's say you invest in a fund because of its value approach; it buys companies temporarily out of favor and holds them until they turn around. A year later, the manager begins buying growth stocks. Even if the returns are good, it's not the fund you thought you'd purchased. Holding it could seriously upset your asset allocation and the level of volatility in your portfolio.

Sell the fund if its beta—a measure of its volatility relative to the overall stock market—is substantially greater than the average of the funds in its investment category. A gap could mean the fund has drifted from its original mandate. Or check to see whether the fund's prospectus indicates a shift in strategy.

"Many of our new clients' portfolios started out fairly well diversified, with six to 10 mutual funds," says Greg Ghodsi, senior vice president of investments for Robert W. Baird & Co. in Tampa. "These people assumed that once they established an asset allocation, they wouldn't have to touch a thing. Unfortunately, as the years passed, some of the funds became tech-heavy. When we ran a computer program that examines the stocks in each fund, it wound up that, for some people, two-thirds of the companies were in the technology sector."

Another concrete sell sign is a poor three-year return vs that of the fund's peer group. The key words here are "peer group," notes financial planner Steven B. Enright of River Vale, NJ. "Just because a fund has lost 20 percent this year doesn't mean you should sell it. It may still be one of the better performers in its investment category, and you may need this type of fund to be properly diversified." A good rule of thumb is to stay with a fund that consistently ranks in the top two quartiles of its peer group.

Also, check the average price-earnings ratio of the equities in the fund, to see whether the manager is holding a lot of pricey stocks, advises Jerome Hamon, an investment analyst with L.J. Altfest & Co. in New York City. "If it's at least 20 percent higher than the average for other funds in the same category, that's not a good sign," he warns.

Consider, too, the flow of money in and out of your mutual funds. The top-performing funds get huge inflows of cash, which can hamstring the manager's ability to purchase good stocks. A small-cap manager, especially, may not be able to find enough to invest in because securities laws prevent the fund from owning too large a percentage of any one company. If you see significant inflows, keep a closer eye on the fund's performance. On the other hand, if a fund has more money going out than coming in for three consecutive quarters, that too could spell trouble. The manager might have to sell some stocks to cover redemptions, socking you with capital gains.

If you're not sure why your fund manager is making certain moves, call your financial adviser or the fund's investor relations department. You can also check the fund company's Web site, where you should find the fund's annual and semiannual reports, as well as an explanation for its recent performance. Sophisticated corporate sites—Fidelity's and T. Rowe Price's, for example—often include audio and video clips from fund managers, plus market commentary from economists and analysts.

Abandon the losers, or hang on and pray?

Maybe you haven't been following the advice in the accompanying article and are stuck with stocks and mutual funds that are way off their highs. If so, you're far from alone. But should you stay put or immediately rejigger to get your portfolio in balance?

At this point, hanging on makes sense in many cases. "If you don't intend to retire for at least 10 years, hold tight, especially if the money is in a tax-deferred plan, such as an IRA or 401(k)," says Robert M. Doran, a financial planner in Wantage, NJ. "Selling now would lock in your losses. In fact, I'd suggest adding to your positions while the market's down and prices are low. If you're investing, say, $1,000 a month, try to make it $2,000. Likewise, if your portfolio doesn't already include growth or aggressive-growth investments, maybe now's the time to buy some."

"If the beaten-down investments are in a taxable account," he adds, "you might consider selling one or more to generate a tax loss. You can then take the proceeds and buy a similar stock or fund, assuming you're still comfortable with that type of investment." According to the IRS' wash-sale rules, you'd have to wait 31 days after the sale in order to buy the same stock or fund.

Many people, Doran says, make the mistake of selling their aggressive investments when prices are depressed and putting the proceeds into relatively low-yielding money-market funds or Treasury bonds. "That stops the bleeding but also eliminates the opportunity to recoup losses in a reasonable amount of time," he says. Moreover, no one can predict the right time to shift some or all of those fixed-income investments back into growth.

Instead of trying to time the market, focus on slowly returning your portfolio to an asset allocation that lets you sleep comfortably. "Our clients who reallocated their investments in 2000 to more value and less growth will probably be in the black this year," says Denver financial planner Lawrence Howes.

Meet at least once a year with your adviser to review your portfolio. And don't hesitate to phone or send e-mail in between meetings if you're concerned about something. As the debacle in technology has taught us, the risk of your individual investments can change: Something that looks promising today may look less so in six months or a year, and could seriously upset your asset allocation.

 

Dennis Murray. Decide what to sell. Medical Economics 2001;21:85.