Sell When Fundamentals Falter
| Stock Selling
Strategies Sell When Fundamentals Falter |
|
|
|
|
This may seem to be a no brainer, but it is often overlooked. You should consider selling a stock when its fundamentals change.
What are fundamentals? Ultimately, whatever your investing style, everything comes back to profits. Profits make the world go round and stocks go up. Without profits you just have a pocketful of dreams.
If you're invested in a speculative stock with no profits, you want to see growing revenues and decreasing losses as the stock must eventually become profitable. If these do not materialize, no matter how large or apparently successful a company is, it will falter and its stock price will fail. Witness the debacle that hit Priceline yesterday.
Amazon.com is possibly the most successful of the new economy Internet companies. But it must show a profit some time. And not just a profit, but galloping growth in profits, to sustain its valuation. Investors will only sustain current valuations if they see such growth as a realistic possibility. Indeed we see headlines like Amazon Defends Strategy to Investors which notes that its shares have been "battered by concerns over whether it will ever turn a profit". It's not surprising that the stock is off over 60% from its highs in December.
Although there are a number of fundamentals one can look at, including price to earnings ratios and debt load, I'll focus here on two - revenues and earnings.
Revenues
If a company has been seeing growing revenues (and a growing stock price) and all of a sudden, revenue growth slows down or reverses in a quarter - watch out! It could be the harbinger of bad news for the stock price. How quickly a stock's price reacts to such bad news depends on a number of factors, including whether the company is, in fact, profitable.
If the company is profitable, it can probably sustain a bad quarter. They do happen occasionally. And the stock's price may remain buoyant, especially if there is an explanation for current woes and they are expected to be a temporary occurence. But a second quarter of declining revenues often hits a company's stock price hard.
If the company is not profitable, a slowdown in revenue growth can halt the stock's advance, if not reverse the trend.
What is significant is how the revenue picture changes. A company that has been experiencing marginal growth and suddenly starts growing revenue by 30% a quarter will see its price gain. But a company whose revenues have been advancing by 60% quarter over quarter and sees growth slow to 30% a quarter will see its stock price falter. And if its market valuation has been built up by expectations of continuing high growth, the stock price will retreat.
In both cases, the company is experiencing 30% growth for the quarter. But the effect this has on stock price depends on previous history. Revenue must be looked at in the context of the company.
Earnings
Then there are earnings, or profits. Ultimately, these are more important than revenue growth because the sustainability of the company depends on it. Companies without profits "burn" through money. To survive they must refinance or turn the company around.
In the dot-com world of today, much has been written about burn rates. And some dot-coms have been devastated by high burn rates and slow revenue growth. Witness Dr. Koop, Book4golf.com and others.
If a company is not yet profitable, it must show rapidly declining losses - a trend that will ultimately put the company into a profitable position. If losses accelerate or even remain steady, the company will eventually hit the wall.
Investors will tolerate losses if they see a light at the end of the tunnel. But they don't like to wander around blindly. No light, no support.
If the company is profitable, then it fits either of two categories - a mature company whose profits are steady and reliable or a company that is growing.
Mature companies are often bought for their dividends, an opportunity to share in the company's fortune. These are blue chip stocks, old stalwarts. The stock price of these companies are usually fairly stable or they grow at a modest rate as the company plows some profits back into operations or the value of the company's assets increase in value.
But if such a stalwart experiences a reversal, the rock becomes slippery. The stock price can drop considerably. No stock, even a supposedly old reliable one, is immune from failure. Just look at the constantly changing makeup of the Dow Jones Industrial Average. Old stocks are dropped and new ones added as the economy changes. There are no buggy whip companies on the DJIA!
What about fast growing companies whose profits are growing steadily as well? Here risk sometimes increases as the growth of the stock price often outstrips the growth of the company. A slowdown in growth, or worse, a decline into a loss, will kill the stock price.
One of the buzz words today is "earnings surprise". A negative earnings surprise almost always sends a stock price dipping.
The key here, as with revenues, is to compare current quarterly results with past results and with expectations. Failure to meet the Street's expectations is a killer.
Always keep your eye on revenues and earnings, comparing them to the past and to expectations. And if warning signs appear - prepare to bail out.
Downside to Selling on Faltering Fundamentals
The only danger of this method is that the company may be experiencing a temporary setback that will quickly reverse itself in the near future. You must be careful to determine the reasons for a decline in revenues or earnings. If they are because of one time costs, re-organization, or increased R&D spending, the problem could be short-lived.
You should consider adopting a cautious stance after one bad quarter, but sometimes it's better to wait for a second bad quarter for confirmation before selling.
Summary of Advantages
and Disadvantages
of Selling on Faltering Fundamentals
| Advantages | Disadvantages |
| The soundest methodology. | Company's setback could be temporary. |
| Risk reduction. | Hidden but acceptable factors could account for setback. |
| Preservation of Capital. |
ZZZNEWSLETTERSIGNUP1ZZZ