It's Time To Sell High

Most investors I know, myself included, are far better at buying stocks than parting with them. Maybe it's because many of us were reared in the late 20th century, when buy-and-hold strategies worked well. Maybe it's because we rarely, if ever, monitor sell decisions. When you buy a stock, it enters your portfolio, and there it is every time you check your account, making you constantly aware of how that decision is turning out. But how many of us keep up with stocks we've sold? In my case, it's out of sight, out of mind.

My traditional focus on buying is one of the reasons that I introduced the Common Sense guide to buying and selling, which has been the underpinning of this column since its inception. At periodic intervals, this system forces me to be disciplined and take some profits when stocks are high. As I've explained in previous columns, my goal is simply to buy low and sell high. When the market drops, I add to my holdings at intervals of 10% declines in the Nasdaq composite index, my preferred barometer. During rallies, I sell some of my stocks at intervals of 25% advances. These numbers aren't arbitrary. They're the midpoints of average bear market declines (20%) and bull market rallies (50%).

This system has the virtue of simplicity, and it has also proven extraordinarily effective. It is inherently contrarian, since selling thresholds tend to occur when the market is fueled by investor optimism, and buying when pessimism is rampant. Selling should be a happy occasion, with the market buoyant and profits in hand. That it often isn't is a testament to the staying power of fear and greed, Wall Street's guiding emotions. Market peaks often coincide with periods of greed, and that's when, in selling, some investors are consumed with fear that they're getting out too soon. That's exactly the kind of emotion we need to get over.

So it makes me happy to report that without a great deal of fanfare or eye-popping rallies, the stock market moved into a selling range this spring. The Dow industrials hovered near a six-year high. Transports were at a record. Consumer confidence hit a four-year high in March. Of greater significance for my purposes, the Nasdaq was over 2300, not far from the 2365 that would be a 25% gain since my last buy signal in April 2005.

This disciplined system for buying and selling isn't an exact science. You don't have to do it all exactly at 2365. You can sell some as the Nasdaq approaches it, some as it reaches it and some as it goes over or pulls back. The important thing is to sell something. The question is, sell what?

One obvious approach is to sell broad index mutual funds and exchange-traded funds. They mirror the major market averages and thus are perfect candidates for divestiture. But that's hardly the only option. Just as I believe it's possible to beat the averages with a modicum of good stock picking when you buy, the same is true when deciding to sell. Lurking in your portfolio may be stocks that represent good value even with the averages at lofty levels. But you may also be sitting on some big profits in stocks that have become overvalued. If and when a market decline comes, those pricey stocks are likely to fare much worse than your other holdings, so disposing of them now could help you outperform a market that is flat or declining.

But here's the rub: Chances are, those overvalued stocks with big gains are the ones you love the most. They're the ones that have made you feel smart, not to mention richer. This warm and fuzzy attachment is an emotion you have to conquer.

To identify candidates to sell, I've usually zeroed in on those stocks that have gained the most since the last buying opportunity, which in this instance was roughly a year ago. After considerable reflection, I decided to refine that exercise, seeking those stocks that have not only gained the most, but are also most likely to be overvalued. My starting point was SmartMoney.com's Contrarian stock screen, which was designed to identify undervalued stocks. I simply put the screen in reverse to generate a list of potentially overvalued issues. The key elements were large price gains over the past year and a high price/earnings ratio relative to expected profit growth. Specifically, I generated a list of those stocks that were among the top 25 percent gainers in the past 12 months and that had P/E-to-growth ratios of more than 2.

The resulting list of 134 stocks contained high-profile companies with big recent runups like Nasdaq (NDAQ) (the market, which has its own shares), Red Hat (RHAT), Celgene (CELG), Toyota (TM) and Starbucks (SBUX). But there were many other, less familiar names: Finisar (FNSR), Joy Global (JOYG) and Aqua America (WTR), to name a few. And there were some surprising omissions. Hansen Natural (HANS), which has more than quadrupled in the past 12 months, missed the cut because earnings projections are so strong that its PEG ratio is just 1.6. Google (GOOG), which doubled in the past 12 months, is even less expensive on that basis, with a PEG of just 1.4.

A benefit of screening is that it's thorough and absolutely objective. My screen forced me to reconsider Tellabs (TLAB), which I've recommended in my online column. It hadn't been in the news much lately, and the one time it was, the shares dropped on what I considered potentially good news: AT&T's (T) decision to buy BellSouth (BLS). Investors feared that Tellabs would lose BellSouth as a customer, though it seems just as likely to me that it will end up expanding its relationship with the enlarged AT&T. Yet my screen revealed the cold facts: Tellabs has doubled in the past year, and it sports a PEG ratio of nearly 3. Even after its pullback, the stock seems wildly overvalued. In fact, when I multiplied the PEG by the 12-month percentage price change to create a measure of overvaluation, I found the result — 276 — was among the highest of the stocks on my list.

Another Common Sense favorite on the list was Monsanto (MON), the once-unpopular maker of bioengineered seed and other agricultural products. I realized Monsanto had done well since I recommended it in this column, but I didn't expect to find it in this exalted company. Multiplying its one-year gain of almost 38 percent by its PEG of 2.29, its overvaluation index number was 86, near the bottom of my list, but still on it.

What if you're not so fortunate as to own one or more of the potentially overvalued stocks on my list? No cause for alarm. You can expand these parameters, increasing the percentile of price gains and decreasing the PEG ratio until some of your stocks show up. If you find yourself adjusting the screen so much that your portfolio consists mainly of value stocks, you can decide to sell only index funds and ETFs or to skip the sales and raise cash by putting money you earmarked for the stock market into short-term savings.

In any event, how much cash to raise at these thresholds is a highly individual decision. I am not an advocate of full-scale market timing, so I confine my selling to 10 percent or less of my portfolio's value. Aggressive investors might want to sell more. But whatever you decide, I urge you to do something. This system has worked well over the years, and I have found it both prudent and profitable to realize some gains when these opportunities arise. They don't come that often, so you might as well enjoy them when they do.