Sunday, June 28, 2009

The Toughest Investing Question is When to Sell?

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Here is an article first published on the RAOMABO (Research and Analysis of Merger and Buyout Opportunities) Website that I think is interesting and relevant in these times:-

We considered various issues and decided on five signals that will warrant a reason to sell a Stock if you owned it or even sell short if you don’t own it...

As the sage of Omaha - Warren Buffet puts it, it’s often, “easier to figure out the losers.”

Referring to the automobile industry, WB points out that although it was one of the the most important inventions of the 20th century, it was very hard to make money as an investor in the industry. Thousands of upstart automakers failed. So the easiest money to be made was on the short side…

Today, we’ll concentrate about individual “loser” i.e. companies that are likely have more downside ahead of them than upside. We’ll see how it is often easier to spot these than the next winners, specially in a market with so much head wind against it ... like today’s markets.

We’ll also look at selling some of your former winners. These are stocks that may have made you good money but are beginning to show signs that you’re better off selling them than holding on to them.

Essentially it all boils down to the most important question in investing: When to Sell?

We’ve found that there are some major red flags you can use to get out of a long position… and go short a stock you don’t own, as well…

Red Flag # 1: High Valuations without High Growth

If you had the foresight to buy a small coffee chain named after an obscure literary character, you would have rode through some fantastic profits. All through the 1990’s and even through the tech-bust, it seemed like Starbucks would never cease to open more stores.
Around that time a Starbucks started opening across the street from another Starbucks, though, it was time to get out. Their growth prospects have been hammered. Other coffee chains are after their alluring market share. Even fast food chains have entered the business.

Today Starbuck’s balance sheet looks like a wreck. Let’s take a quick look. With a trailing P/E of 127, the company fails to pass an analyst’s first evaluation of a company’s value. The profit margin is less than 1% and the operating margin is 5%. Debt is three times cash. Return on equity, one of our preferred valuation measures, is 3.5%. Clearly, yesterday’s winners can become today’s losers.

Red Flag # 2: Technological Changes Taking Away a Former Competitive Advantage

Change is the only factor that’s constant in investing. Technological changes can make an entire company or industry’s products obsolete.

That doesn’t necessarily mean to go long the new technology. You should just avoid the obsolete one, or even short it as it dies off. Within the auto industry, we’ve seen technological changes that are partially responsible for the sad state of American automakers.

Toyota Motors was the first to market hybrid vehicles — namely its flagship Prius. The rest of the industry has been playing catch-up ever since. Sure, foresight is imperfect, and entrenched interests kept American automakers from fully adapting to this threat. But the solution wasn’t to go long Toyota; it was to stay away from General Motors, Ford, and Chrysler. Add in their uncompetitive cost structures, and it’s clear who the losers would be in this industry.

Red Flag # 3: The Company Begins to Use Questionable Accounting

Reading boring financial statements may tell you if you’re invested in the next Enron or Worldcom. Bad companies try to hide poor performance with financial gimmicks. One of the biggest things we’re looking at in the current investment environment includes companies reporting profits substantially in excess of reputed analyst expectations.

If such gains come from cutting costs, like firing employees, then the numbers being reported aren’t going to be sustainable over time. It’s the opposite of real sales growth and it’s a way of hiding a decline.

A lot of service-based companies are guilty on this count in recent quarters, from retailers to restaurateurs. Think of it as mold that people mistake for green shoots. It’s just too toxic to invest in.

The other major accounting areas to look at in this earnings environment are receivables and inventory. If Accounts Receivable is rising, there could be a problem with customer’s ability to repay... or there’s a problem with lax credit to customers to buy products. Either way, it’s one of the most obvious red flags you can see without. Eventually, toxic AR has to be written off. And the imaginary gains have to become real losses.

Rising inventories are even more problematic. A store offering this year’s fashions at 50% off may be able to post some good sales numbers, but over time it’s a recipe for disaster. Deeper and prolonged sales shorten the life of the business as lower margins choke off cash flow. Think Circuit City, Linens and Things, Mervyn’s and a host of other retailers. The retail industry’s problems are not over by a long shot.

Red Flag # 4: Divestiture to Meet a Cash Crunch or Burning the Furniture for Heat

Companies worth owning for the long- term don’t need to issue new debt right now. They certainly don’t need to go to the capital markets and issue stock to shore up reserves, either.

While this clearly applies to all the household-name financials, other companies have quietly been raising capital in the midst of this bear market rally as well. Any company that has to sell off assets or divisions right now is one worth reevaluating. Even in the absence of the worst credit crunch of all time, it would still be a very red flag.

Within this category insider selling is worth a mention. It’s a form of raising equity - only it benefits management and not the company. Certainly non insider the shareholders don’t benefit. Combined with other red flags, it’s the closest thing to a leading indicator we’ve seen that a stock is going to fall. Be especially aware of multiple insiders selling.

Red Flag # 5: Key Related Industries Are Suffering

There’s more than one way to make a profit. In investing, the term ‘pin action’, stolen from bowling, means that if one industry is on fire, related industries will share the heat as well. The same thing applies when it’s time to sell.

Watch the Flags...

Take a good hard look at the positions in your portfolio, and the major positions in any mutual funds you own. If your rationales for buying no longer apply or if any of the changes listed above are occurring, you might want to take some money off the table.

After a run-up, is the perfect time to re-balance your entire portfolio — to reduce risk by getting out of toxic assets and into better ones. When the market comes crashing down again, you’ll have more capital preserved to invest in companies that are innovative, growing, diverse, and ethical—and still have some left over to short the losers.

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